What is the Solvency Ratio?

The solvency ratio is used to examine the ability of a business to meet its long-term obligations. The ratio compares an approximation of cash flows to liabilities, where a high ratio is an indicator of financial strength. Conversely, a low ratio indicates that a business might have trouble meeting its obligations.

Who Uses the Solvency Ratio?

The solvency ratio is most commonly used by current and prospective lenders. They need it to ascertain whether a borrower has sufficient excess cash flow available to pay back any credit granted to it. Investors also use the ratio to gauge the risk of losing their investments in targeted businesses. When these parties decide that the calculated ratio is too low, it can be quite difficult for a business to obtain additional funding.

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How to Calculate the Solvency Ratio

The solvency ratio is derived from the information stated in a company's income statement and balance sheet. Its calculation involves the following steps:

Add all non-cash expenses back to after-tax net income. This should approximate the amount of cash flow generated by the business. Typical add-backs are depreciation expense and amortization expense.
Aggregate all short-term and long-term obligations of the business.
Divide the adjusted net income figure by the liabilities total.

The formula for the ratio is:

(Net after-tax income + Non-cash expenses) ÷ (Short-term liabilities + Long-term liabilities) = Solvency ratio

A higher percentage indicates an increased ability to support the liabilities of a business over the long-term. A lower percentage indicates that a business may be in danger of defaulting on its obligations.

The ratio will not be accurate to the extent that an organization does not recognize contingent liabilities.

Problems with the Solvency Ratio

Though this measurement appears simple, its derivation hides a number of problems. For example, a company may have reported an unusually high proportion of earnings not related to its core operations, and which may therefore not be repeatable during the time period required to pay off the company's liabilities. Consequently, net after-tax operating income is a better figure to use in the numerator. Also, the short-term liabilities used in the denominator are more likely to fluctuate considerably in the short-term, so the measurement results could vary widely if calculated just a few months apart. This issue can be mitigated by using an average short-term liabilities figure. Finally, the ratio assumes that a company will pay off all of its long-term liabilities, when it may be quite likely that the business can instead roll forward the debt or convert it to equity. If so, even a low solvency ratio may not indicate eventual bankruptcy. In short, there are so many variables that can impact the ability to pay over the long term that using any ratio to estimate solvency can be dangerous.

Similar Solvency Ratios

There are several other solvency ratios that can be used in concert with the solvency ratio, or as replacements to it. They are:

Debt to equity ratio. This ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations.
Interest coverage ratio. The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. This measurement is used by creditors, lenders, and investors to determine the risk of lending funds to a company. A high 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.