Solvency Ratios

A Solvency ratio can be recognized as one of the key metrics to determine whether an organization can stay solvent or not in the long term. It is a comprehensive measure of solvency (liquidity) as it essentially measures the organization’s actual cash flow instead of the net income. It does so by adding back the depreciation and all the other non-cash expenses to assess an organization’s potential to stay afloat. It must be noted that the Solvency ratio may vary with different companies and thus, the results should always be compared with their main competitors in the same market/industry instead of reviewing the results in an isolated manner. 

Uses and Importance of Solvency ratio 

By using the solvency ratio, the measurement of cash flow capacity versus all the liabilities can be done instead of focusing on the short-term debt only. This is an efficient method to assess the company’s long-term health as a more in-depth evaluation of key areas of the company like the company’s repayment ability for its long-term debt and interest on that debt. 

How to calculate Solvency Ratio?

The solvency ratio measures the company’s cash flow which includes all the depreciation and non-cash expenses against all debt obligations. There are a lot of solvency ratios that are used to measure the solvency of an organization like; the Interest Coverage ratio, Debt-to-Assets ratio, Equity ratio, and Debt-to-Equity ratio. 

Solvency Ratio Formula

 There are a variety of different solvency ratio formulas. Some of the methods to calculate the solvency ratio of a company are discussed as follows;

1. The Interest Coverage Ratio- This can be calculated by dividing the earnings before interest and taxes (EBIT) of the company by the interest expenses of the company. This ratio calculates how many times the concerned company can cove their current interest payments with the earnings they have currently.  
2. Debt-to-Assets Ratio- This is calculated as; Debt divided by Assets. This simple ratio states the ratio of the company’s total debt to its total assets. This measure gives a great understanding of the financial backing of the company and its leverage. The higher the ratio (more than 1), the more difficult position the company is right then in terms of debt obligations.
3. Equity Ratio- Also known as the shareholder equity ratio (SER), it is calculated by TSE divided by Total assets (where TSE refers to Total Shareholder Equity). The higher the number is in this case, the healthier the company is financial. 
4. Debt-to-Equity Ratio- A very common method is the Debt-to-Equity ratio which is calculated by simply dividing the debt outstanding divided by the Equity of the company.

Limitations of Solvency ratios

There are a few drawbacks of the solvency ratio measure and the results may not be always true to the real scene in the concerned company. Some of the drawbacks are as follows;

1. Even if a company has a low debt amount, if their cash management practices and financial strategies are poor, over time they will make poor decisions that will eventually cost them and their solvency position may not be that solid even if the solvency ratio told another way. 
2. To truly understand the situation of the company, the solvency ratio of that company needs to be compared with their peers as only their result is not enough to give them a proper idea of how good or bad, they are doing in terms of being solvent. Thus, it is time taking.
3. The solvency ratio does not take many factors and aspects of a company into consideration that further limits the reliability of the measure.  

Conclusion

The solvency ratio is an essential measure to figure out the solvency of an organization, and assess the financial condition concerning their competitors in the same industry, quantitatively. Specific aspects and numbers of the company are considered to calculate these numbers and then, the solvency is achieved. The measure has its flaws but still acts as a helpful guide for an organization’s management and financial decision-makers.