Solvency Ratio: What it Means and How to Calculate it for Business Valuation
We will cover everything from types of solvency ratios to examples of solvency ratios here.
Companies prefer to raise money through debt capital because it is the most cost-effective way. By doing so, they may avoid the exorbitant interest rates of borrowing money from banks. However, if a business raises more money than is necessary, the interest cost will damage its profits and balance sheet.
The debt component of a business may be compared using ratios, especially the solvency ratio. An evaluation of the solvency ratio is something that stakeholders could take into consideration. This measure is helpful for anybody who would want to do business with a firm, including lenders, investors, suppliers, and customers.
If you’re wondering how to calculate the solvency ratio or how it will impact your business valuation, this article is for you. We will cover everything from types of solvency ratios to examples of solvency ratios here.
Solvency Ratio and Business Valuation
The solvency ratio is a common method of assessing a company’s financial health by comparing its profitability against its debt commitments. A high solvency ratio is recommended since it demonstrates fiscal stability. A low ratio, on the other side, may indicate future financial difficulties. Let’s understand how the solvency ratio works in the following section.
What is the Solvency Ratio?
Prospective business lenders often use a solvency ratio to evaluate an organization’s capacity to fulfill its long-term loan commitments. A firm’s solvency may be evaluated by determining whether or not its current assets cover its long-term debts. An unfavorable ratio may suggest that a corporation is likely to fail on its loan. Each sector has its benchmark ratio that is considered optimal. However, a solvency ratio over 20% is generally seen as favorable. A greater solvency ratio indicates that the corporation is generating more revenue per rupee of debt. If the company can boost its net profits or reduce its financial liabilities, its solvency ratio will improve.
What Do Solvency Ratio Measures?
The ability of a business to remain financially stable over time is evaluated using a variety of criteria called the solvency ratio. If you want a full picture of a company’s ability to remain afloat, go as far as the solvency ratio, which gauges the company’s real cash flow after deducting for things like depreciation and other non-cash costs.
This ratio evaluates the company’s ability to generate cash flow relative to its total debt load, not just its short-term debt. By measuring the company’s capacity to pay back its long-term debt and interest, solvency ratios indicate the company’s long-term financial health.
Types of Solvency Ratio
With financial measures, we can compare an organization’s long-term debt to its stock and assets in a useful way. Interested parties may evaluate the firm’s capital structure using various ratios. The following are some solvency ratios used to assess a company’s capacity to repay future loans.
- Debt-to-Equity (D/E) Ratio – The debt-to-equity ratio, sometimes written as D/E, measures the indebtedness of a firm to its equity. You’ll need the company’s total debts before calculating the ratio. Calculate this number and divide it by the entire amount of stock in the firm. The level of leverage (the use of debt to support operations) is quantified by this metric.
- Interest Coverage Ratio – By looking at the interest coverage ratio, you can calculate how often a company’s earnings may be utilized to pay the interest on its obligations. The value is determined by dividing the company’s pre-tax income by interest expenses. A higher number indicates that the firm is financially stable. This signifies that the business is making money via normal operations and can pay its interest.
- Debt-to-Capital Ratio – As suggested by its name, the debt-to-capital ratio measures how much of a company’s total capital is supported by debt. If a corporation has a debt-to-capital ratio of 0.45, it indicates that 45 percent of its capital is provided by debt. In this situation, a smaller ratio is better since it suggests that the corporation can fund capital without heavily depending on the debt.
How to calculate the solvency ratio?
The solvency ratio should be used in combination with additional financial metrics and qualitative data to construct a complete evaluation of the business’s solvency and financial condition. Nonetheless, it stands alone as a measure of financial health.
Here are a few steps you can follow to find the solvency ratio.
- Gathering necessary financial information – First, get your hands on the company’s financial records, especially the most up-to-date balance sheet. The balance sheet is an overview of the business’s financial standing, displaying its wealth and debts and providing other relevant information.
- Calculation of total assets – Using the balance sheet, list every asset owned by the firm. Assets may be anything of value, such as money in the bank or other liquid form, stock on hand, or physical structures like buildings and machinery, as well as investments and other monetary holdings. The assets’ overall value is determined by adding together these assets’ values.
- Calculation of total liabilities – Examine the company’s financial sheet and compile a full list of its debts. Liabilities may be current (like accounts payable) or future (like loans, bonds, or accumulated costs). The total amount of liabilities may be determined by adding together all the individual liability amounts.
- Calculation of solvency ratio – The final step is to calculate and find the outcome. The solvency Ratio is calculated using the following formula.
Example of solvency ratio
Let’s assume that we have a business and its name is XYZ Inc. We may infer the following details from their balance sheet:
- Assets as a Whole – $800,000
- Expenses as a Whole – $1,200,000
The ratio is calculated as follows:
- Net Assets / Overall liabilities = $800,000 / $1,200,000
- Ratio of Solvency = 0.67
The solvency ratio for XYZ Company is 0.67 in this scenario. This suggests the firm may be in danger of insolvency since its total assets are fewer than its total obligations. If a company’s solvency ratio is less than 1, it may need help paying its long-term debts.
Interpretation of Solvency Ratio
The solvency ratio serves as an important financial indicator that gives insight into the long-term financial health of a firm as well as its capacity to satisfy its debt commitments. When attempting to make sense of the value of the ratio, the following are key considerations to keep in mind.
- Healthy solvency ratio ranges – If a company’s solvency ratio is higher than 1, its assets cover its obligations. However, the optimal ratio might change depending on the business’s sector and other factors. The ratio should be compared to industry standards or historical data to get a full picture of the company’s financial health.
- Implications of high and low solvency ratios – An outstanding solvency ratio indicates the corporation has sufficient assets to meet its obligations. This suggests greater resilience and a reduced likelihood of bankruptcy under adverse economic conditions. Financial crisis or bankruptcy is more likely if a company’s assets are inadequate to meet its obligations, as indicated by a low solvency ratio. This may happen if there is a significant gap between the value of investments and the value of obligations or if there is a lot of debt.
- Comparison of solvency ratio to other financial ratios – The solvency ratio is only one of several financial measures to consider when assessing a company’s financial health. One way to evaluate a company’s capacity to satisfy its short-term commitments is to compare its solvency ratio to other liquidity ratios, such as its current or fast ratio. Similar to how profitability ratios assist in evaluating a business, cash flow measures help evaluate whether or not a firm is generating enough cash to pay its bills.
Limitations of Solvency Ratio
There are certain limitations to just relying on the solvency ratio when evaluating a company’s financial health, despite the fact that it is one of the most crucial ratios to examine.
- A high solvency ratio is just one indicator of a company’s health. It does not ensure stability.
- A corporation can put its substantial debt to good use. However, a reduced ratio might mislead stakeholders about the organization.
- Certain businesses can’t function without more debt and less cash on hand. For instance, the solvency ratio of a telecommunications company will be smaller than that of a fast-moving consumer goods company. Investors may be misled if they make a direct comparison of the solvency ratios of these companies.
- The ratio does not explain why it is greater or lower; it just indicates the value.
Need Help Calculating your Solvency Ratio for Business Valuation?
The solvency ratio is a useful indicator of a company’s financial health when combined with other measures. A more accurate conclusion may be reached by comparing the solvency ratios of many companies. Eqvista offers a whole platform for analyzing and understanding important financial parameters like the solvency ratio with our cutting-edge financial modeling instruments and expertise. Our intuitive design and powerful tools will aid you in making informed company valuation choices and providing insightful analysis. Want to ensure a strong financial future for your business? Choose Eqvista today!