Solvency Ratio Analysis: What it is and why it’s Important
Solvency ratios are designed to measure the overall profitability of a business by comparing profitability levels against current financial obligations. Calculating and analyzing these ratios can provide business owners, CFOs, investors, and banking institutions with valuable financial insights including the company’s ability to meet its current long-term debt obligations.
Calculating the company’s solvency ratios is just as important for small businesses as it is for larger ones. But calculating a ratio is only the first step. Equally important is solvency ratio analysis, which examines ratio metrics and builds a more complete picture for management, investors, creditors, and lenders to review.
What is solvency?
The concept of solvency is quite simple. As a business owner, you always want more assets than liabilities. To be considered solvent, a business should be able to pay their bills both short term and long term.
In many cases, the solvency of a business can be easily assessed by reviewing the business balance sheet and cash flow statement. However, investors, creditors, and analysts often turn to solvency ratios to better determine solvency. Solvency ratios also help business owners and CFOs keep an eye on company trends, particularly if debt continues to increase without a concurrent increase in revenue or assets.
Common solvency ratios
There are numerous types of solvency ratios that can be calculated to determine company solvency, with four used most frequently.
- Debt to asset ratio
- Debt to equity ratio
- Equity ratio
- Interest coverage ratio
Each of these solvency ratios measures the solvency (or insolvency) of a different portion of your company.
Staying on top of issues such as liquidity and solvency can help you be more proactive in managing your company’s financial health; addressing red flags as they occur, not months, or even years down the road.
Solvency vs. liquidity: What’s the difference?
Though often confused with liquidity, solvency addresses the long-term financial health of your business, while liquidity focuses on how quickly a business can convert current assets into cash.
Not only does solvency look at whether your business can meet current financial obligations, but it also examines whether your business can meet long-term obligations well into the future.
Though it’s possible to have low liquidity but remain solvent, it’s best if your business is both liquid and solvent.
How to calculate your small business’ solvency
To be solvent, you must own more than you owe. While reviewing financial statements is a good start in determining solvency, there are numerous solvency ratios that you can calculate to determine how solvent your business is.
Debt–to-asset ratio: If you only run one solvency ratio, it should be the debt-to-asset ratio. This ratio measures the percentage of assets that are currently financed with both short-term debt and long-term liabilities. A higher number means higher leverage, and more financial risk, while a low ratio indicates stability.
The formula to calculate your debt-to-asset ratio is as follows:
Total Liabilities / Total Assets = Debt-to-Asset Ratio
For example, for the fiscal year 2020, Sky Manufacturing had total assets of $7 million and total liabilities in the amount of $4.5 million on its balance sheet. To calculate Sky’s debt-to-asset ratio you would perform the following calculation:
$4,500,000 / $7,000,000 = 0.64
This result indicates that almost 65% of Sky Manufacturing’s assets are funded by debt. While not in the danger zone, many financial experts recommend a total debt-to-asset ratio of 0.5 or less for the best financial stability.
Debt-to-equity ratio: If you’re concerned about the amount of outstanding debt you’re financing compared to your total equity, the debt-to-equity ratio can be helpful. The debt-to-equity ratio can vary widely from industry to industry, so it’s best to compare your results to similar companies.
To calculate the debt-to-equity ratio, just locate your total liabilities and your total shareholder’s equity on your current balance sheet. The formula to calculate the ratio is as follows:
Total Liabilities / Total Shareholder’s Equity = Total Debt-to-Equity
We already know that Sky Manufacturing’s liabilities total $4.5 million, with assets of $7 million, so their equity would be $2.5 million. We can calculate the debt-to-equity ratio as follows:
$4,500,000 / $2,500,000 = 1.8
This result indicates that for every $1 of equity, Sky Manufacturing is currently carrying nearly $2 in company debt.
A good debt-to-equity ratio is less than 1, while a ratio of 2 or higher indicates higher risk. Like most ratios, it’s best to compare your results with those in your industry.
Equity Ratio: If you’re concerned about being over-leveraged, one of the best ratios to calculate would be the equity ratio. A leverage ratio, the equity ratio gives you a quick summary of how much debt you’re currently carrying relative to current assets.
The formula for calculating the equity ratio is:
Total Equity / Total Assets = Equity Ratio
Using Sky Manufacturing’s numbers from above, let’s calculate total equity.
$2,500,000 / $7,000,000 = 0.36 or 36%
This result means that investors are funding only 36% of the company’s assets, with creditors funding the balance. A good equity ratio is usually 50%, with anything below 50% considered leveraged, meaning that Sky finances more assets using debt rather than equity. A higher ratio means that assets are funded with equity.
Interest Coverage Ratio: The interest coverage ratio centers on one specific area of your business: it measures how well you can meet the interest expense on any debt your business is currently carrying. While not every business will need to run the interest coverage ratio, it can be helpful for businesses that carry a lot of debt.
To calculate the interest coverage ratio, you’ll first have to obtain your operating earnings, which are earnings before interest and income taxes, commonly abbreviated as EBIT. You can get your company’s EBIT total from the income statement.
To calculate the interest coverage ratio, use the following formula:
EBIT / Interest Expense = interest coverage ratio
We’ll say that Sky Manufacturing had an EBIT of $1.4 million and interest expenses of $940,000.
$1,400,000 / $940,000 = 1.49
In general terms, an interest coverage ratio should be at least 2. Anything lower can signal that a business may be unable to cover all of its debt in the future.
In addition to these common solvency ratios, you may find the current ratio and the quick ratio useful. The current ratio compares current assets to current liabilities, while the quick ratio measures short-term obligations using only liquid assets.
What do the results mean?
Solvency ratios can help you assess company solvency, but won’t provide you with all the information you need to make an informed assessment. For example, while the ratio results will point out how much of your assets have been financed using debt, they don’t provide necessary details such as what those assets are and what they’re used for.
Using Sky Manufacturing as an example, let’s start with their debt-to-asset ratio of 0.64. While not a red flag, this result indicates that nearly two-thirds of Sky Manufacturing’s assets are funded by debt, rather than by equity. If this ratio increases, it can put the company in the danger zone, and send a message to investors and financial institutions that the business is not sustainable.
Next, let’s look at their debt-to-equity ratio of 1.8. Since industry standards can vary, it would help to compare this result to similar manufacturing companies. Since most industry experts suggest a debt-to-equity ratio of 1 or less and place a 2 in the danger zone, Sky Manufacturing is in the middle with a 1.8 result. If this does not increase, they will likely remain a good option for investors and a safe bet for lenders.
Sky’s equity ratio results came in at 36%, meaning the company is leveraged. A higher ratio of more than 50% is viewed by investors and lenders as conservative; meaning that it uses more debt to acquire assets. But financial leverage is not always a bad thing, particularly for newer companies. However, if Sky Manufacturing could raise the level closer to 50%, they would be more attractive to investors.
Finally, Sky’s interest coverage ratio is 1.49. This result indicates that the company can pay its current interest payments about one and a half times. Most industry experts prefer to see a 2 but are not overly concerned unless the interest coverage ratio drops to 1 or below.
Analyzing these ratio results together, it looks like Sky Manufacturing is operating adequately, with some room for improvement, including working to increase their net income while decreasing the amount of debt on the books.
Using solvency ratios and analysis properly
When calculating solvency ratios, you must do the following:
- Analyze results: While calculating the ratio is an important first step, it serves no purpose if those results are not properly analyzed.
- Track results long term: If you run solvency ratios once, they serve no purpose. Instead, be sure to calculate them regularly, paying close attention to trends. A good solvency ratio today may be trending downward, while a poor result may trend upward. Only by paying attention to these trends can you make informed decisions about your company.
- Always compare results to similar companies: If you have a computer repair business, you don’t want to compare your solvency ratio results with those of a manufacturing company. Always compare results within your industry.
Staying on top of issues such as liquidity and solvency can help you be more proactive in managing your company’s financial health; addressing red flags as they occur, not months, or even years down the road. When used with other financial ratios such as liquidity ratios, the capital ratio, or the quick ratio, solvency ratios can help you be better prepared for the future and ward off potential issues before they occur.