Meaning and definition of solvency ratio
Solvency ratio is one of the various ratios used to measure the ability of a company to meet its long term debts. Moreover, the solvency ratio quantifies the size of a company’s after tax income, not counting non-cash depreciation expenses, as contrasted to the total debt obligations of the firm. Also, it provides an assessment of the likelihood of a company to continue congregating its debt obligations.
The formula used for computing the solvency ratio is:
Solvency ratio = (After Tax Net Profit + Depreciation) / Total liabilities
As stated by Investopedia, acceptable solvency ratios vary from industry to industry. However, as a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound. Generally, a lower solvency ratio of a company reflects a higher probability of the company being on default with its debt obligations.
Different forms of solvency ratios
Generally, there are six key financial ratios used to measure the solvency of a company. These include:
- Current ratio
Computed as Current Assets ÷ Current liabilities, this ratio helps in comparing current assets to current liabilities and is commonly used as a quantification of short-term solvency.
- Quick ratio
Also known as ‘liquid ratio’ and computed as Cash + Accounts Receivable ÷ Current liabilities, considers only the liquid forms of current assets thus revealing the company’s reliability on inventory and other current assets to settle short-term debts.
- Current debts to inventory ratio
Computed as Current liabilities ÷ Inventory, this ratio reveals the reliability of a company on available inventory for the repayment of debts
- Current debts to net worth ratio
Computed as Current liabilities ÷ Net worth, this ratio indicates the amount due to creditors within a year’s time as a percentage of the shareholders investment
- Total liabilities to net worth ratio
Computed as Total Liabilities ÷ Net Worth¸ this ratio reveals the relation between the total debts and the owners’ equity of a company. A higher ratio indicates less protection for business’ creditors.
Computed as Fixed Assets ÷ Net Worth, represents the percentage of assets centered in fixed assets I comparison to total equity.