Solvency ratios
/What are Solvency Ratios?
Solvency ratios allow you to discern the ability of a business to remain solvent over the long term. They provide this insight by comparing different elements of an organization's financial statements. Solvency ratios are commonly used by lenders and in-house credit departments to determine the ability of customers to pay back their debts. It is especially useful to track solvency ratios on a trend line, to see if the ability of a business to pay back its debts is declining.
Solvency Ratios vs. Liquidity Ratios
Solvency ratios show the ability of a business to meet its long-term debt obligations, while liquidity ratios show its ability to meet short-term obligations. A business might appear to have significant liquidity in the short term, and yet be unable to meet its longer-term obligations. Thus, a business can appear to be quite liquid, and yet proves to be insolvent over the long term. This situation can arise when a business has just received a large payment from a customer, but has such a poor sales backlog that it will not be able to continue generating positive cash flow over the long term. The reverse situation can also arise, where a business is not especially liquid over the short term, and yet is highly solvent when viewed over a longer period of time.
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Examples of Liquidity Ratios
Examples of solvency ratios are noted below, where we describe the current ratio and quick ratio. The quick ratio is preferred when a business has invested in a substantial amount of inventory, since it can be difficult to liquidate inventory on short notice.
Current Ratio
The current ratio is current assets divided by current liabilities, and indicates the ability to pay for current liabilities with the proceeds from the liquidation of current assets. The formula is:
Current assets ÷ Current liabilities = Current ratio
A ratio of 2:1 is considered reasonable. The ratio can be skewed by a large amount of inventory, which can be hard to liquidate in the short term. Accordingly, this ratio works best on businesses that maintain low inventory levels, such as service organizations.
The current ratio is not a good indicator of the long-term solvency of a business, since it is only used to compare short-term assets and short-term liabilities.
Quick Ratio
The quick ratio is the same as the current ratio, except that inventory is excluded (which makes it a better indicator of solvency). The remaining assets in the numerator are more easily convertible into cash. The formula is:
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Quick ratio
This is a good choice for reviewing the solvency of a business that keeps large amounts of inventory on hand. Any ratio greater than 1:1 is considered reasonable.
Since the quick ratio only compares current assets and current liabilities, it is not a good indicator of the long-term solvency of a business.
Examples of Solvency Ratios
Examples of solvency ratios are shown below, where we highlight the debt to equity ratio and the interest coverage ratio. These ratios focus attention on whether a business is able to comfortably service its debt obligation over the long term.
Debt to Equity Ratio
The debt to equity ratio compares the amount of debt outstanding to the amount of equity built up in a business. To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is:
(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio
If the ratio is too high, it indicates that the owners are relying to an excessive extent on debt to fund the business, which can be a problem if cash flow cannot support interest payments.
A high debt to equity ratio is especially dangerous when an organization’s cash flows are variable, as is the case with a start-up business or one that operates within a highly competitive industry. Conversely, a business may be able to comfortably maintain a high debt to equity ratio if it operates in a protected market where cash flows have historically been reliably consistent.
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. A high interest coverage ratio indicates that a company can pay for its interest expense several times over, while a low ratio is a strong indicator that a company may default on its loan payments.
If there is a specific ratio that is considered to be the essential solvency ratio, it is a comparison of profits before non-cash items, divided by all liabilities. The formula is:
(Net after-tax profits + Depreciation + Amortization) ÷All liabilities = Interest coverage ratio
If a business has taken out loans that have variable interest rates, then it makes sense to review this ratio frequently, to determine the effects of changes in interest rates on the firm’s ability to pay. When interest rates spike, it is possible that a business that had previously produced a conservative interest coverage ratio is now on the verge of bankruptcy.
Understanding Solvency and Liquidity Ratios
It can be dangerous to base a lending decision on a loan applicant's solvency and liquidity ratios as of a specific point in time. Doing so presents the risk of not spotting a negative trend in this ratio that may have started several years before the reporting date. To avoid this problem, calculate the ratios for several years and plot them on a trend line. It may also be useful to extend these ratios into the future, both through extrapolation and by using the applicant’s budgeted financial statements for the next year.
In addition, these ratios can vary widely by industry. What might appear to be a solid solvency ratio in one industry might be considered quite poor in another, so be sure to compare this information to the average for the relevant industry.
Finally, it is useful to compare a firm’s reported profit levels to its solvency and liquidity ratios. If its reported profit level is on a downward slope, it is likely that the associated decline in cash inflows will eventually cause its solvency and liquidity ratios to worsen. Thus, profitability is a good leading indicator of problems that might not appear in these ratios for another year or two.
Problems with Solvency Ratios
The main problem with solvency ratios is that there is no single ratio that provides the best overview of the solvency of a business. Instead, these ratios need to be supplemented with other information to gain a more complete understanding of whether an organization can consistently pay its bills on time. This entire set of information must then be compared to similar information for the rest of an industry, to see how well a business compares to its peers.
Another concern with solvency ratios is that they do not account for the ability of a business to obtain new long-term funding, such as through the sale of shares or bonds. These ratios also do not account for the presence of existing lines of credit that can be drawn down to access additional funding on short notice. When there is a large and mostly untapped line of credit, a business can easily pay its bills even when its solvency ratios are showing a bleak picture of its ability to pay.
A third problem with these ratios is that they do not provide any insight into new lines of business that a company is rolling out, and which might be starting to generate significant positive cash flow. Conversely, the ratios also do not reveal whether existing investments are turning out poorly, resulting in poor returns on investment (if any). These issues are important, since they can impact a firm’s solvency in the near term.