In the pursuit of more profits and growth, a company will have to look for sources of funds.
One source of funds is debts.
Of course, having debt means having obligations to pay, and creditors/lenders will have to assess a company’s ability to pay before lending their cash to a company, lest they risk losing their money.
This ability to pay all obligations, be it short-term or long-term, is what we refer to as solvency.
When a company is confident that it can pay all of its debt obligations when they become due, then that company knows that it’s solvent.
But how exactly does a company knows that it is solvent?
A simple glance at a company’s balance sheet may give you an idea of a company’s solvency.
But other than that, there are metrics that specifically measure a company’s solvency.
These metrics are what we call solvency ratios.
What are solvency ratios?
As already mentioned, solvency ratios are metrics that measure a company’s solvency.
These ratios are similar to liquidity ratios in that they measure a company’s capability to pay its debts, but rather than just the short-term, solvency considers all debts obligations.
In short, liquidity relates to short-term debts, while solvency refers to short-term and long-term debts. In a way, solvency ratios assess a company’s long-term financial health.
A company with good solvency ratios means that the company is solvent and will have no trouble paying its debts.
If one or some of the solvency ratios aren’t good though, this may indicate that a company has some areas in which its solvency is lacking.
If all of a company’s solvency ratios aren’t good, then that company might go into bankruptcy if the solvency issues aren’t fixed.
Solvency ratios can also be referred to as leverage ratios.
The commonly known solvency ratios include:
The solvency ratio measures a company’s ability to pay its debt and other financial obligations with its cash flow.
This is similar to the operating cash flow ratio (a liquidity ratio) in that it uses a company’s cash flow as a measurement.
The main difference is that the solvency ratio considers all liabilities rather than just current liabilities.
A company with a low solvency ratio could mean that that company is at high risk of default.
This is a turn-off for creditors and potential investors as lending or investing their money to such a company could mean that they won’t be getting their money back.
On the other hand, a company with a high solvency ratio is more likely able to pay off all its debts, which makes them more attractive to lenders and investors.
The level of adequate or good solvency ratio depends on the industry that a company belongs in, but in general, a solvency ratio of 20% or higher is already considered good.
The solvency ratio can be computed using the formula:
|Solvency Ratio =||Net Income + Non-cash Expenses|
*Non-cash expenses include depreciation and amortization
Let’s try computing the solvency ratio using the formula above.
From the financial statement of LL company, we gathered the following information:
Using the formula above, we arrive at:
Solvency Ratio = (Net Income + Non-cash Expenses) / Total Liabilities
Solvency Ratio = (33,500 + 5,150 + 3,330) / 150,000
Solvency Ratio = 41,950 / 150,000
Solvency Ratio = 0.28 or 28%
As per computation, LL company’s solvency ratio is 0.28 or 28%.
This means that it can pay off 28% of its total liabilities with just its cash flow alone, and if this level of solvency ratio is kept constant, then LL company might be able to pay off its debts in more or less 3.6 years.
Also known simply as the Debt Ratio, the debt-to-assets ratio measures the level of debt a company has relative to its assets.
It can also be viewed as the percentage of assets that are financed by debt.
Most companies have a mix of debt and equity for their financing structure.
While there is no standard for the appropriate mix of debt and equity, it’s still a good idea for a company to know its debt-to-assets ratio.
A high debt-to-assets ratio would mean that a company is skewed more towards debt financing rather than equity financing.
This is not an issue if a company can produce enough income to compensate for the cost of debt (e.g. interest expense).
However, if a company has historically inconsistent levels of profits, it might be a good idea to lower its debt-to-assets ratio.
If a company’s debt-to-assets ratio is more than 1.0 (e.g. 1.1 or 110%), then that means that a company has more liabilities than assets.
In general, this is not a good picture as it might mean that the company is having difficulties in paying off its debts.
It could also mean that the company is not doing a good job in utilizing the funds it got from debt financing as it was not able to convert them into additional assets.
To compute the debt-to-asset ratio, the following formula is used:
Debt-to-Assets Ratio = Total Liabilities / Total Assets
Let’s go back LL company example above which has a total liabilities of $150,000.
Let’s say that LL company has total assets of $300,000.
Using the formula above, we compute for LL company’s debt-to-assets ratio:
Debt-to-Assets Ratio = Total Liabilities / Total Assets
Debt-to-Assets Ratio = 150,000 / 300,000
Debt-to-Assets Ratio = 0.50 or 50%
As per computation, LL company has a debt-to-assets ratio of 0.50 or 50%. This means that 50% of its total assets are being financed by debt.
Similar to the Debt-to-Assets Ratio, the Debt-to-Equity Ratio measures the level of debt a company has.
However, instead of relating it to total assets, it’s about the relationship between a company’s total liabilities and its total equity.
It is also a quantitative measurement of a company’s debt-equity mix. For example, if a company has a debt-to-equity ratio of 3, that means its debt-equity mix is 3:1 (for every $1 of equity, there is $3 of debt).
A debt-to-equity ratio of greater than 1 means that a company is financed more by debt rather than equity.
If it is lesser than 1, then a company is financed more by equity rather than debt. If it is exactly 1, then a company is equally financed by both debt and equity.
The debt-to-equity ratio is also an indicator of the ability of a company’s shareholders’ equity to pay off all of its outstanding loans in the extreme case of a business downturn.
The formula commonly used for computing the debt-to-equity ratio is as follows:
Debt-to-Equity Ratio = Total Liabilities / Total Equity
*There are some cases where shareholders’ equity is used instead of total equity which is sometimes referred to as the Debt-to-Capital Ratio
Let’s say that a company has total liabilities of $100,000 and total equity of $400,000, and we want to know its debt-to-equity ratio.
Using the formula above:
Debt-to-Equity Ratio = Total Liabilities / Total Equity
Debt-to-Equity Ratio = 100,000 / 400,000
Debt-to-Equity Ratio = 0.25 or 0.25:1 or 1:4
From the computation above, we can see that the company has a debt-to-equity ratio of 0.25.
It could also be interpreted as the company having a debt-equity mix of 1:4.
This means that the company is financed more by equity rather than debt.
Interest Coverage Ratio (ICR)
Debt obligations such as loans and bonds come with interest.
It is also referred to as time interest earned (TIE) as it measures the number of times a company can pay for its interest expense with just its earnings/operating income.
The interest coverage ratio also presents a company’s margin of safety regarding interest expense.
While an ICR of 1 may seem enough as it means that a company can pay for its interest expense with just its earnings, remember that there are still taxes to pay.
Not to mention surprise dips in revenue, and you suddenly don’t have enough earnings to cover all expenses (including interests and taxes).
An ICR of just 1 is not enough.
A company needs to have a higher ICR for it to be comfortable with its financial position.
The formula for computing the interest coverage is as follows:
|Interest Coverage Ratio =||Operating Income or EBIT|
*EBIT means earnings before interests and taxes.
Let’s say Company ZX has an operating income of $60,000 and an interest expense of $15,000.
We can compute for the ICR by using the above formula:
Interest Coverage Ratio = Operating Income / Interest Expense
Interest Coverage Ratio = 60,000 / 15,000
Interest Coverage Ratio = 4 or 4x
This means that Company ZX can cover for its interest expense with just its earnings at most 4 times before it has to tap onto its cash and cash equivalents.
An ICR of 4 can also be comfortable enough to account for unexpected dips in revenue or any other factors that can affect the company’s financial well-being.
Uses of Solvency Ratios
Solvency ratios are useful for both internal and external users.
Lenders/creditors use solvency ratios to assess whether a company is eligible for a loan.
Since solvency ratios measure a company’s ability to pay all of its debt obligations, lenders/creditors can use them to assess whether a company could repay them should they lend their money.
A company with poor solvency ratios will most likely find it hard to secure a loan from lenders/creditors, whereas a company with great solvency ratios will have no trouble securing loans.
Owners use these ratios to assess the financial well-being of their company.
A company that cannot pay its liabilities will always be a red flag, be it for current or potential investors.
If an owner knows that the company’s solvency isn’t looking great, s/he will most likely find ways to improve it, such as investing more capital or shying away from more debts.
Solvency ratios can also be used by management.
They can use them to make decisions regarding debt, such as deciding whether to pursue additional debt or not.
If management finds that having more debt result in lesser net income, they may suggest to the owners to not pursue additional debts.
Limitations of Solvency Ratios
While solvency ratios can be useful tools for measuring a company’s financial well-being, they should not be looked upon in isolation.
For example, a company may have a high debt-to-assets ratio, which may be considered to be risky by most investors, but if it has a very high interest coverage ratio, would it still be considered a risky company to invest in?
Another would be a company having good overall solvency ratios, but poor liquidity ratios.
While yes, such a company can answer for its debts in the long run, but if it cannot pay for its short-term debts in time, would it still be considered a financially sound company?
Solvency ratios on their own are just numbers and as such, won’t tell you the whole story.
To make the most out of them, you would need to compare them with the solvency ratios of a previous period to know if the company was able to maintain or even improve its solvency.
They should also be compared to other companies within the same industry to assess whether a company is competitive and within industry standards.
Knowing that a company has a debt-to-equity ratio of 3:1 is not enough to know if it has adequate debt levels or not.
Another limitation of solvency ratios is that they are computed based on historical data.
These ratios do not account for future transactions.
Suppose a company suffers an unpredictable great loss and as a result, its solvency is jeopardized. Solvency ratios cannot account for such unpredictability.
Why should companies care about their solvency?
Solvency means staying power. That’s why a company needs to monitor its solvency.
If a company loses its ability to pay for its debts, bankruptcy would surely follow.
After that, dissolution will likely be the next to happen.
Track your company’s solvency ratios!
Doing so will not only provide you with information about your company’s solvency but will also help you in reducing the risk of bankruptcy.
Knowing your company’s solvency ratios can also help your company decide whether it’s worth it to take on another debt or not.
Having attractive solvency ratios will make it easier for your company to apply for loans or seek other forms of debt financing.
Just be mindful of your debt levels.
Stay within the appropriate level of solvency ratios and your company will more than likely stay in business for years to come.
How can your company stay solvent?
The short answer to this question is to remain profitable.
Easier said than done right?
Although, making profits is already the purpose of putting up a business so this answer is already a given.
Another way of staying solvent is to be mindful of your company’s debt levels.
Be sure to keep your amount of debt within an acceptable level.
Refrain from taking in more debt if it can hurt your company’s profit generation in the long run.
Solvency Ratios and Liquidity Ratios – are they the same?
Although solvency ratios and liquidity ratios are similar in that they measure a company’s financial health, they are not the same.
Liquidy ratios deal more with short-term obligations and liquid assets.
An example of this is the current ratio which is an indication of the relationship between current assets and current liabilities.
Solvency ratios on the other hand deal with the total assets and total liabilities.
Just take a look at the debt-to-assets ratio which is an indication of total assets and total liabilities.
In short, while similar, they are not the same.
Liquidity ratios focus more on the short-term, while solvency ratios focus more on the long-term.
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