• Solvency ratios provide an indication of a company’s ability to maintain profitability, while meeting future debt obligations.
• The four primary solvency ratios to consider include interest coverage, debt-to-asset, equity and debt-to-equity.
• Solvency ratios can provide investors with an idea of a company’s sustainability, from which to make an investment decision.
A key indicator of the potential health of a company over the long term, solvency ratios can illustrate the efficiency with which companies pay off debt, make interest payments and employ assets to support operations.
In other words, a company’s solvency ratio can serve as an indicator of its ability to meet long-term liabilities, which in turn is a reflection of the health of its finances.
Useful for the evaluation of the profitability of a company, investors can use this data to learn about the financial viability of a company
The following explains how to find and interpret a solvency ratio.
A comprehensive examination of soundness, solvency ratios measure cash flow as opposed to net income. This is because they factor in depreciation and additional non-cash costs in their assessments of a company’s potential to remain viable.
Said differently, a company’s cash flow capacity is evaluated against all of its liabilities, rather than simply its short-term financial obligations. In so doing, solvency ratios can illuminate a company’s ability to meet its long-term debt obligations—as well as make the interest payments on those debts.
However, it is important to note solvency ratios can vary by industry. When using them as tools for measure, they are best applied to direct competitors in a specific field of endeavor. Employed within that framework, solvency ratios can help project future cash flows, monitor long-term liabilities, establish budgets and evaluate financial risk.
While the term may lead one to believe solvency ratios are a single metric, they are actually comprised of a number of metrics designed specifically to measure financial consistency in long-term debt repayment, accrued interest, tax deferments and outstanding shares using cash flow and assets.
Ultimately, solvency is calculated based upon several different ratios, using particular formulas. One can then aggregate financial data on long-term interest, assets, liabilities and equity. This data can then be recorded on a balance sheet alongside liquidity values.
Private Market Investing 101, with Kal Penn
The primary formula for the calculation of a company’s overall solvency ratio is as follows:
Solvency Ratio = (Net Income + Depreciation) / (Short-term + Long-term Liabilities)
The numerator (Net Income + Depreciation) represents current cash flow, while the denominator (Short-term + Long-term Liabilities) is comprised of financial obligations. This enables the calculation to reveal a company’s ability to meet its combined liabilities.
As an example, consider a scenario in which the fictional company, Perpetual Motion Industries (PMI), has $90m in net income, $30m in depreciation, $166m in short-term liabilities and $320m in long-term liabilities.
Applying the formula above, PMI’s solvency ratio could be calculated as follows:
(90m + 30m) / (166m + 320m) = .246
Multiplying .246 by 100 returns a product of 24.6%
Thus, PMI’s solvency ratio is 24.6%
A company is typically considered sound when its solvency ratio is 20% or better. Based upon these calculations, it is reasonable to expect PMI to be debt-free within approximately four years — assuming the metrics upon which the calculations above are based hold fast (100%/24.6%).
In addition to the overall solvency ratio, there are four other key types of solvency ratios to consider. These include interest coverage, debt-to-asset, equity and debt-to-equity solvency ratios.
Interest coverage ratios express the rate at which a company’s current available cash flow will allow it to meet its current interest obligations. Generally, a ratio of 1.5 or above is considered promising. This ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses. This calculation can also provide an indication of the number of times a company can cover those expenses with currently available earnings.
Debt-to-asset ratios compare total debts to total assets. Calculating this metric will reveal whether a company employs assets more than debt to fund operations. This can provide a sense of how heavily the company is leveraged. It can also reveal how capable a company is at allocating assets to address its obligations. A good debt-to-asset ratio is typically one or below. Dividing total debt by total asset value returns this metric.
Equity ratios are comparisons of equity to assets, which can reveal the amount of equity a company uses to finance its operations. Dividing total shareholder equity by total assets returns this metric. Higher ratios indicate more equity is being employed than debt. Lower ratios indicate a company is using more debt than equity to support its undertakings.
Debt-to-equity ratios are a measure of the amount of debt with which a company is funding operations compared to equity. It is important to monitor this metric in order to ensure the company’s ability to resolve debts should liquidation become necessary. This calculation is accomplished by dividing all outstanding debt by the total value of the company’s equity.
While a useful tool, it is critical to understand solvency ratio calculations and fail to consider the ability of a company to engage new sources of funding. After all, offering stocks and bonds can provide fresh infusions of capital — along with new financial obligations.
In other words, a solvency ratio calculation is only capable of providing a snapshot of a company’s situation as of a particular moment in time. Therefore, it is important to consider it in conjunction with additional means of financial analysis in order to gain an all-inclusive synopsis of the solvency of a business.
While a high overall solvency ratio can be an indication of stability, it is also important to consider the debt-to-equity ratio, debt-to-asset ratio and the others listed above to get the clearest possible picture of a company’s standing before considering an investment.
Seasoned investors understand the importance of considering all of these calculations before making an investment. Equally important is evaluating investments with an eye toward an individual investor’s objectives, time horizons and risk tolerance. With this in mind, portfolio diversification can be of great importance when it comes to managing the ebbs and flows of the market in general.
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In some cases, this risk can be greater than that of traditional investments.
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Conducting due diligence to ensure a company can maintain solvency over the long term is of paramount importance before placing an investment. Calculating solvency ratios can provide insight into a company’s capacity for meeting its debt obligations — and paying them off — over the long term.
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