Can the company keep its head above the water?
What is a solvency ratio? This is a question that many business owners and individuals ask when they are looking to invest in a company. The solvency ratio is used to measure the financial stability of a company. It is calculated by dividing the company’s total liabilities by its total assets. This number tells you how likely it is that the company will be able to pay off its debts. In this blog post, we will discuss why the solvency ratio matters and how you can use it to make informed decisions about your investments!
What are Some Examples of Solvency Ratio
Solvency ratios are measures of company financial health. At its most basic, solvency ratios compare a company’s cash commitments to its ability to pay on those commitments. You may use a few different ratios as a measure of solvency, depending on the information you are trying to glean from the company’s financial statements. You may be looking at short-term debt or you may be considering the long-term financial well-being of the company. Here are some ways to calculate solvency ratios.
Interest Coverage Ratio
As the name indicates, Interest Coverage Ratio shows the ability of the company to pay interest on its debt. This is more of a short-term view. It answers the question “Does the company generate enough cash to pay interest on its debt and keep its obligations in good standing?”. This ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its total interest expenses.
Interest Coverage Ratio = EBIT/Total Interest Expense
For example, if Company XYZ has an EBIT of $100,000 and total interest expenses of $50,000, their interest coverage ratio would be: 100,000/50,000= 2
This solvency ratio would be considered good because the company is generating enough cash to cover its interest expenses and then some. An Interest Coverage Ratio below 1.5 can be considered problematic.
Debt-to-Equity Ratio
The debt-to-equity ratio measures the percentage of a company’s assets that are financed by debt. This solvency ratio can give you an idea of how leveraged a company is. A higher debt-to-equity ratio means that the company is more leveraged and may have difficulty meeting its financial obligations if business conditions turn sour. This ratio is calculated by dividing a company’s total liabilities by its shareholder equity.
Debt-to-Equity Ratio = Total Liabilities/Equity
For example, if Company XYZ has total liabilities of $100,000 and shareholder equity of $200,000, their debt-to-equity ratio would be: 100,000/200,000= 0.50
This solvency ratio would be considered good because the company has more assets than it does liabilities. A debt-to-equity ratio that is too high can be a red flag that the company is over-leveraged and may be at risk of defaulting on its debt obligations.
Debt-to-Asset Ratio
The debt-to-asset ratio measures the percentage of a company’s assets that are financed by debt. This solvency ratio is similar to the debt-to-equity ratio, but it includes all assets in the denominator. This ratio is calculated by dividing a company’s total liabilities by its total assets.
Debt-to-Asset Ratio = Total Liabilities/Total Assets
For example, if Company XYZ has total liabilities of $100,000 and total assets of $200,000, their debt-to-asset ratio would be: 100,000/200,000= 0.50
This solvency ratio would be considered good because the company has more assets than it does liabilities. A debt-to-asset ratio that is too high can be a red flag that the company is over-leveraged and may be at risk of defaulting on its debt obligations.
Equity-to-Asset Ratio or Equity Ratio
The equity-to-asset ratio measures the percentage of a company’s assets that are financed by equity. This solvency ratio is the inverse of the debt-to-asset ratio and can give you an idea of how leveraged a company is. A lower equity-to-asset ratio means that the company is more leveraged and may have difficulty meeting its financial obligations if business conditions turn sour. This ratio is calculated by dividing a company’s total equity by its total assets.
Equity Ratio = Total Shareholder Equity/Total Assets
For example, if Company XYZ has total equity of $100,000 and total assets of $200,000, their equity-to-asset ratio would be: 100,000/200,000= 0.50
This solvency ratio would be considered good because the company has more assets than it does equity. An equity-to-asset ratio that is too low can be a red flag that the company is over-leveraged and may be at risk of defaulting on its debt obligations.
Why is the Solvency Ratio Important for Investors
The solvency ratio is an important tool for investors because it can give you an idea of how well a company can meet its financial obligations. If a company is over-leveraged, it may be at risk of defaulting on its debt obligations. This could lead to the loss of your investment. At the very least, the long term return on your investment may be abysmal if the management continues to mismanage the capital of the company.
It is important to remember that solvency ratios are just one tool that you can use to analyze a company. It is important to look at a company’s solvency ratios in conjunction with other financial information before making an investment decision.
What are Some Things a Company can do to Improve its Solvency Ratio?
There are a few things a company can do to improve its solvency ratio:
- Reduce its total liabilities
- Increase its total equity
- Sell assets to pay off debt
- Raise capital by issuing new equity or taking out loans
- Replace management with more competent managers who are disciplined about capital allocation
As a shareholder, you can still influence the management policies by voting up or down on the projects that may be brought up to the shareholder vote.
What are Some of the Risks Associated with a Low Solvency Ratio
Low solvency ratios (or high values in the case of debt/equity or debt/asset ratios) raise red flags for investors because they may be indicative of an over-leveraged company at risk of defaulting on its debt obligations. This could lead to the loss of your investment. Even if the company can manage this situation, it will still be unable to access new financing at competitive rates, and that will hamstring its efforts to invest in new growth opportunities.
What are Some of the Benefits of a High Solvency Ratio
High solvency ratios (or low values in the case of debt/equity or debt/asset ratios) are beneficial to the company because they indicate that the company is less leveraged and may be able to meet its financial obligations. This could lead to higher stock prices and increased investor confidence. The company can use its strong balance sheet to access new financing and invest in new growth opportunities.
How Solvency Ratios and Liquidity Ratios Differ
Solvency ratios bear a close resemblance to liquidity ratios, and in fact, a deteriorating liquidity situation does indicate a company that is veering towards insolvency. However, solvency ratios also measure long-term solvency, while liquidity ratios focus on a company’s ability to meet its short-term obligations.
Solvency ratios take into account a company’s long-term debt, while liquidity ratios only consider its current liabilities. Additionally, solvency ratios use total assets in the denominator, while liquidity ratios use current assets.
The solvency ratio is an important indicator of a company’s overall financial health and long-term viability. Investors should be aware of the solvency ratios of any companies in which they are considering investing and should avoid companies with unhealthy ratios. A healthy solvency ratio means that the company is on stable ground and is likely to remain solvent for the foreseeable future, making it a safer investment choice. Have you ever looked at a company’s solvency ratio before investing? If not, we hope you will start doing so now. It can mean the difference between losing your money and keeping it safe and sound.