Solvency Ratio and How Is It Calculated

The solvency ratio is one of these crucial indicators of utmost significance for businesses and investors. By evaluating a company’s capacity to fulfill its long-term commitments, this frequently used indicator assists investors in reducing investment risks. Investors can choose equities with a higher chance of price appreciation by utilizing the solvency ratio, ensuring their investment decisions align with their profitability objectives.

Let’s see the solvency ratio, its types, and the calculation formula in detail.

What is a Solvency Ratio?

The solvency ratio is a financial indicator that assesses a company’s capacity to handle its long-term obligations. It reveals its proficiency in generating cash flow to meet upcoming debt responsibilities. This ratio provides an understanding of the financial well-being of a business and helps investors, managers, and shareholders gauge profitability more effectively. The solvency ratio combines several elements and is typically incorporated into a thorough analysis that assesses a company’s capacity to maintain profitability over the long term.

The actual cash flow should first be considered in solvency analysis rather than only the net income. Companies evaluate their genuine financial capacity by considering elements like depreciation and costs. Additionally, experts consider all financial commitments rather than just a company’s short-term liabilities when assessing solvency.

Understanding Solvency Ratios

The solvency ratio is a measure used to assess a company’s long-term solvency and ability to maintain a profit. These ratios evaluate solvency by considering things like depreciation and other non-cash expenses, giving a more precise picture of a company’s survival ability. 

Solvency ratios thoroughly evaluate a company’s financial condition and ability to sustain solvency over the long term by taking actual cash flow into account. Let’s take a closer look at them.

• Long-Term Solvency Ratio 

This solvency ratio assesses a company’s ability to generate cash flow and satisfy its long-term obligations rather than only concentrating on short-term debt. A solvency ratio thoroughly evaluates a company’s capacity to honor its financial commitments over the long term by considering all liabilities, including long-term debt and related interest payments. In simple terms, it assesses the company’s long-term viability by looking at its capacity to pay off long-term debt and the monetary impact of that debt.

• Short-Term Solvency Ratio 

It measures the company’s ability to convert its current assets, such as cash, accounts receivable, and inventory, into cash to cover its short-term liabilities, such as accounts payable and short-term debt.

• Solvency Ratio in Insurance 

It measures a company’s financial stability and ability to endure unfavorable circumstances. The ability of an insurance company to meet its financial responsibilities and preserve market stability is assessed using these ratios by regulators, policyholders, and other stakeholders.

Solvency ratios differ across industries. Therefore, evaluating a company’s solvency ratio, including insurance firms, compared to competitors is crucial. This comparison research gives essential information about how a company’s solvency ratio compares to industry standards and norms and offers a clearer picture of its financial situation.

List of Solvency Ratios

The solvency ratio has several types:

• Long-Term Debt-to-Equity Ratio;
• Total Debt-to-Equity Ratio;
• Debt Ratio;
• Financial Leverage;
• Proprietary Ratio.

#1. Long-Term Debt-to-Equity Ratio

The long-term debt-to-equity ratio is a measure for assessing the degree of leverage a company uses. To calculate this ratio, divide the company’s long-term debt by its common and preferred stock’s combined value. The following is the equation to determine the long-term debt-to-equity ratio:

Long-term debt-to-equity ratio = Long-term debt / (Common stock + Preferred stock)

It is calculated to understand future risks and ensure that the company can pay interest on the debt if its cash flows decrease.

A larger long-term debt-to-equity ratio enhances the risk of a company going bankrupt. When interest rates are rising, when a company’s cash flow is subject to considerable volatility, or when it has little cash to cover its debt commitments, this risk is more important. The larger ratio in such cases highlights the company’s future financial difficulties.

The long-term debt-to-equity ratio can be used to compare a company’s degree of leverage to that of its rivals, assessing the reasonableness of the company’s leverage. However, the standard debt-to-equity ratio offers a more complete index of a business’s financial health because it considers both long-term and short-term debt. It is significant when an organization has a significant amount of debt that will mature soon and is not captured by the long-term debt-to-equity ratio alone. 

#2. Total Debt-to-Equity Ratio

The debt-to-equity ratio (D/E ratio) is a measure that indicates the level of debt a company has about its assets. The amount is determined by dividing the company’s total debt by shareholder equity. 

A higher D/E ratio denotes more debt than equity in the company because many of its resources are going towards debt service. It may make it more difficult for the business to meet its financial commitments.

The formula for calculating a company’s debt-to-equity ratio is:

Debt-to-Equity Ratio = Debt Outstanding / Equity

The debt-to-equity ratio includes both short-term and long-term debt. Short-term debt represents borrowings with a shorter repayment period that ranges from a few months to 6-12 months. Whereas long-term debt refers to the equity shareholders invest in the business over an extended period.

With the help of the D/E ratio formula, investors and business owners can better understand the proportion of debt classified as short-term versus long-term debt. When a company’s debt-to-equity (D/E) ratio is high, it suggests that it might have trouble repaying its debts. So, the total D/E ratio helps evaluate a company’s overall financial health.

#3. Debt Ratio

A company’s debt ratio gives information about its credit financing and the extent to which it depends on loans in relation to its assets. It is determined by dividing the company’s total liabilities by its assets. A higher debt ratio indicates a more substantial reliance on debt financing. Debt ratios can be used to evaluate the financial health of individuals, companies, and governments.

As with other accounting ratios, investors and creditors evaluate a company’s primary financial statements to determine its debt ratio. This ratio aids in their assessment of the company’s overall financial health and ability to manage its debt commitments. The debt ratio can help stakeholders better appreciate a company’s reliance on its cash flow.

The debt ratio is calculated as follows:

Debt ratio = Total Debt / Total assets

The total debt is divided by the total assets to determine a company’s debt ratio. The total debt comprises current and future obligations, like bank loans and credit cards. The total assets, on the other hand, include a variety of categories, such as fixed assets, current assets, and intangible assets.

#4. Financial Leverage

Financial leverage refers to a company’s strategic use of borrowed money to buy more assets to make more money. Although the borrowed money is a liability for the company, it provides income for the lender. 

Businesses use financial leverage to increase their future benefits or profits. They profit from the fact that the expected return on the assets acquired will be greater than the interest or other fees involved with borrowing the money. Businesses can boost their financial performance with this strategy, which may also increase shareholder wealth.

• How to calculate financial leverage?

Financial leverage can be assessed through various calculations using a set of ratios known as leverage ratios. These ratios evaluate the company’s amount of debt concerning different assets. The debt-to-equity and debt-to-assets ratios are the two most popular financial leverage ratios.

• Why is financial leverage important?

Financial leverage gives opportunities for investors, allowing them to increase their returns potentially. But, these opportunities come with potential risks. New investors are advised to understand the concept of leverage and familiarize themselves with the potential downsides.

Investors can boost the potential returns on their cash by leveraging their assets. It’s important to realize that leverage can magnify losses and profits when an investment does not perform as expected. 

#5. Proprietary Ratio

This ratio measures the proportion of a company’s total assets that its proprietors finance. The proprietary ratio determines the degree of ownership or stake the proprietors have in the company by comparing their equity to the total assets.

The proprietary ratio emphasizes the composition of a company’s assets in terms of issued equity shares rather than external debt and offers insights into the stability of a company’s capital structure.

This coefficient is calculated using the following formula:

Proprietary Ratio = Proprietors’ Fund / Total Assets

With a proprietary ratio, one can assess the proportion of shareholders’ equity in relation to the business’s total assets.

Example of Solvency Ratios

The financial situation of Amazon as of the third quarter of 2022 is shown above. Amazon reported having assets worth more than $428 billion as of September 30, 2022.

You can learn more about Amazon’s financial stability by comparing its debt-to-equity ratio from the prior year to the current year. Although the total debt is not shown in the financial statement, it can be calculated by deducting the total shareholders’ equity from the total assets (they are both listed in the report). 

The corresponding ratios for each year are as follows:

• $282,304 / $138,245 (2021 D/E Ratio) = 2.04
• $290,873 / $137,489 (2022 D/E Ratio) = 2.12

These calculations show that while there is a minor rise in financial risk from the end of December 2021 to the end of September 2022, Amazon’s long-term solvency has improved. The company’s debt-to-equity ratio has marginally risen, suggesting a larger amount of debt relative to equity on its balance sheet, which indicates this.

A different instance is Amazon, where the debt-to-assets ratio also soared. This outcome is not unexpected, considering that the company has taken on more debt relative to equity. As a result, the relationship between debt and total assets is anticipated to change, providing all other variables stay the same.

• $282,304  /$420,549 (2021 D/A Ratio) = 0.67
• $290,873 / $428,362 (2022 D/A Ratio) = 0.68

Amazon’s debt-to-assets ratio was 0.67, meaning that for every $1 in assets, debt was used to finance $0.67. It indicates that almost 67% of the company’s assets were financed by debt. 

The debt-to-assets ratio has changed to 0.68 due to a modest increase in debt, meaning that 68% of the company’s assets are now financed by debt. These minor swings are typically unnecessary, but investors should pay special attention to enduring long-term trends or abrupt changes from one period to the next.

FAQs

Below are some of the questions new investors ask about the solvency ratio.

What are Solvency Ratios?

Solvency ratios are vital in assessing the financial well-being of a company. It is important to note that solvency ratios differ from liquidity ratios, as the latter focus on a company’s ability to meet short-term rather than long-term debt obligations.

What Is the Difference Between Solvency and Liquidity Ratios?

By analyzing a company’s capacity to fulfill long-term commitments and repay debt, solvency ratios primarily evaluate the company’s long-term viability and financial health. On the other hand, the liquidity ratio focuses on the company’s short-term financial status, especially its ability to meet immediate financial obligations and maintain sufficient cash flow for current operations.

How Is the Solvency Ratio Calculated?

Any investor can determine a company’s solvency ratios by obtaining the essential information from its financial statements. 

The solvency ratio formula is as follows:

• The debt-to-assets ratio is calculated by dividing the company’s total debt by its total assets. 
• The debt-to-equity ratio is gained by dividing the company’s total debt by its total equity.

Is Solvency the Same as Debt?

Although they are not the same, solvency and debt are intertwined. A company’s solvency measures how well it will be able to pay off its debts. However, in the long run, it’s critical that a business keep track of its obligations and determines if it can pay off long-term debt when it becomes due.

Is the High Solvency Ratio Good?

A company is in a better long-term financial position if its solvency ratio is high, which is generally a positive sign. An excessively high solvency ratio may indicate that the company is not fully utilizing the available low-cost loan solutions. It could suggest that the business is overly dependent on equity funding and is skipping out on prospects for development and expansion through loan financing.

The Bottom Line

In conclusion, solvency ratios offer essential information about a company’s long-term financial health and ability to pay its debts. A high solvency ratio indicates higher stability and the ability to withstand economic crises. 

However, an abnormally high solvency ratio can indicate that debt financing needs to be used to its full potential, thereby limiting chances for expansion. Striking a balance between high operational efficiency and high solvency ratio is crucial. Investors and stakeholders can make wise decisions while comprehending the risks by evaluating solvency ratios and other financial parameters.