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.
It should be noted that the Solvency ratio is often understood not as a specific indicator, but as a group of indicators that find the ratio between the assets and liabilities of the company.
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.
Pros and Сons of Solvency Ratios
The major pros of using solvency ratios are that they are an efficient way to measure a company's ability to pay its long-term debts and can provide a quick assessment of a company's financial health. Additionally, solvency ratios can be used to compare the financial health of different companies in the same industry.
The major cons of using solvency ratios are that they do not take into account short-term debt and may not reflect a company's true financial position. Additionally, a company with a high solvency ratio is not necessarily financially secure, as it may still be operating at a loss or close to bankruptcy. Therefore, it is important to take other financial indicators into consideration when assessing a company's overall financial health.
There are a few peculiarities in the interpretation of solvency ratios for large companies and small businesses. For large companies, solvency ratios can be used to compare the financial health of different companies in the same industry. However, for small businesses, it is important to note that a high solvency ratio is not necessarily an indicator of financial security, as the company may still be operating at a loss or close to bankruptcy. Additionally, due to their smaller size, small businesses often have fewer assets and liabilities than larger companies, which can lead to skewed results when calculating their solvency ratios. Therefore, it is important to take other financial indicators into consideration when assessing a small business's overall financial health.