What is a Solvency Ratio?

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Definition:

A solvency ratio is a financial analysis tool to evaluate a company’s ability to pay its long-term financial obligations.

🤔 Understanding solvency ratios

Solvency ratios are analytical tools that help investors evaluate a company’s ability to pay its long-term debt and interest charges on those debts. Solvency evaluates a company’s capacity to repay long-term debts, while liquidity measures a company’s ability to pay to meet its short-term liabilities. A company seeks to maintain good solvency and liquidity to signal good financial health and financially sustainable operations. Owners, investors, and creditors use data from a company’s financial statements (e.g., balance sheet, income statement) to calculate solvency ratios and estimate a company’s solvency. Examples of solvency ratios are thea debt-to-equity ratio, the equity ratio, and the debt ratio.

Example

One of the solvency ratios is the debt-to-equity ratio:

Debt-to-equity ratio = Total Liabilities / Total Equity

Let’s use Tesla’s balance sheet for the fiscal year that ended Dec. 31, 2019:

Total liabilities: $26.199B Total equity: $6.618B Debt-to-equity ratio: 26.199 / 6.618 = 3.96

(Source: Tesla’s 2019 Annual Report)

A debt-to-equity ratio of 3.96 means that Tesla has $3.96 of debt for every dollar of equity and suggests Tesla has high leverage — use of capital from debt sources to make investments to turn a profit.

Takeaway

Using a solvency ratio is like doing a self-check at mile 16 on a marathon…

You’ll have to pace yourself if you want to complete the 26.2 miles in a full marathon. Doing self-checks every couple of miles helps you track your performance, pay attention to red flags, and make adjustments as necessary. Likewise, a solvency ratio is a snapshot of solvency and helps a company with its goal of long-term financial health.

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What are solvency ratios?

Solvency ratios help you understand a company’s ability to pay its long-term liabilities — debt obligations that are due in more than a year.

Solvency ratios use accounting data from a company’s financial statements, including:

  • Total debt from the balance sheet — an overview of a company’s assets, liabilities, and shareholders’ equity.
  • Earnings before interest and taxes (EBIT) from the income statement — a snapshot of a company’s revenues and expenses.

Examples of solvency ratios include the debt ratio (Total Liabilities/Total Assets), and the interest coverage ratio (Earnings Before Interest & Taxes)/(Interest Expense).

What are the types of solvency ratios?

There are two types of solvency ratios: debt ratios and coverage ratios.

Debt solvency ratios

Debt solvency ratios focus on items from the balance sheet (assets, liabilities, shareholder’s equity) to give you a sense of how much debt a company is using to finance its operation.

Some commonly used debt solvency ratios are:

  • Debt-to-assets Ratio (also referred to as debt ratio) = Total Debt/Total Assets
  • Debt-to-capital Ratio = Total Debt/(Total Debt + Total Shareholder’s Equity)
  • Debt-to-equity Ratio = Total Debt/Total Shareholder’s Equity

Coverage solvency ratios

Coverage solvency ratios use data from the income statement to evaluate a company’s ability to cover its debt.

Two of the most common coverage solvency ratios are:

  • Interest Coverage = (Earnings Before Interest & Taxes)/Interest Expense
  • Fixed Charge Coverage = (EBIT + Lease Payments)/(Interest Payments + Lease Payments)

What are short-term and long-term solvency ratios?

A short-term solvency ratio defines total debt as the sum of current liabilities — the company’s debt obligations that are due within 12 months. Examples of current liabilities are accounts payable, unearned revenue, taxes payable, and accrued payroll and benefits.

Alternatively, a long-term solvency ratio defines total debt as the sum of long-term liabilities — company debt that is payable in over 12 months. A long-term liability is also referred to as a non-current liability. Examples of long-term liabilities include multi-year operating leases, 30-year or 15-year mortgages, and deferred revenue.

The conclusions of the evaluation of a company’s solvency through short-term and long-term solvency ratios typically do not vary by much. If the findings vary significantly, you should investigate more about the cause of that variation.

What are the formulas for the solvency ratios?

The formulas for the most commonly used solvency ratios are:

Debt-to-assets ratio (aka Debt Ratio)

Debt-to-assets-ratio = Total Debt/Total Assets

Debt-to-capital ratio

Debt-to-capital Ratio = Total Debt/(Total Debt + Total Shareholder’s Equity)

Debt-to-equity ratio

Debt-to-equity Ratio = Total Debt/Total Shareholder’s Equity

Financial leverage ratio

Financial Leverage Ratio = Average Total Assets/Average Total Equity

Interest coverage ratio

Interest Coverage = (Earnings Before Interest & Taxes)/Interest Expense

Fixed charge coverage ratio

Fixed Charge Coverage = (EBIT + Lease Payments)/(Interest Payments + Lease Payments)

How do you calculate solvency ratios?

Let’s calculate each one of the solvency ratios. For each of these examples, we’ll reference Paypal’s balance sheet for the fiscal year ending Dec. 31, 2019.

Debt-to-assets ratio

Debt-to-assets-ratio = Total Debt/Total Assets

Total debt: $34.40B Total assets: $51.33B Debt to assets ratio: 34.40 / 51.33 = 0.67 (Source: Paypal’s 2019 Annual Report)

A debt-to-assets ratio of 0.67 indicates that Paypal has 67 cents of debt for every dollar of assets.

Debt-to-capital ratio

Debt-to-capital Ratio = Total Debt/(Total Debt + Total Shareholder’s Equity)

Total debt: $34.40B Total debt + shareholder’s equity: $34.40B + $16.93B = $51.33B Debt to capital ratio: 34.40 / 51.33 = 0.67 (Source: Paypal’s 2019 Annual Report)

A debt-to-capital ratio of 0.67 indicates that Paypal has 67 cents of debt for every dollar of capital from both debt and equity sources.

Debt-to-equity ratio

Debt-to-equity Ratio = Total Debt/Total Shareholder’s Equity

Total debt: $34.40B Total shareholder’s equity: $16.93B Debt to equity ratio: 34.40 / 16.93 = 2.03 (Source: Paypal’s 2019 Annual Report)

A debt-to-equity ratio of 0.67 indicates that Paypal has $2.03 of debt for every dollar equity.

Financial leverage ratio

Financial Leverage Ratio = Average Total Assets/Average Total Equity

Average total assets: ($51.33B + $43.33) / 2 = $47.33B Average total equity: ($16.93B + $15.39) / 2 = $16.16B Financial leverage ratio: 47.33 / 16.16 = 2.93 (Source: Paypal’s 2019 Annual Report)

A financial leverage ratio of 2.93 indicates that every $2.93 of Paypal’s assets support a dollar of equity.

Interest coverage ratio

Interest Coverage = (Earnings Before Interest & Taxes)/Interest Expense

Earnings before interest & taxes (EBIT): $2.72B Interest expense: $0.12B Interest coverage ratio: 2.72 / 0.12 = 22.67 (Source: Paypal’s 2019 Annual Report)

An interest coverage ratio of 22.67 indicates that Paypal has $22.67 of EBIT for every dollar of interest expense.

Fixed charge coverage ratio

Fixed Charge Coverage = (EBIT + Lease Payments)/(Interest Payments + Lease Payments)

EBIT + Lease payments: $2.72B + $0.13B = $2.85B Interest payments + lease payments: $0.12B + $0.13B = $0.25B Fixed charge coverage ratio: 2.85 / 0.25 = 11.4 (Source: Paypal’s 2019 Annual Report)

A fixed charge coverage ratio of 11.4 indicates that Paypal has $11.4 of EBIT for every dollar of interest and lease expenses.

What do solvency ratios tell you?

Solvency ratios tell you about a company’s ability to pay its long-term debts.

Debt solvency ratios like the debt-to-equity ratio and the debt-to-capital ratio provide more insights about a company’s capital structure (how much capital comes from debt sources and how much from equity sources).

Coverage solvency ratios like interest coverage and fixed charge coverage provide more details about a company’s ability to cover its debt payments.

What is a good solvency ratio?

The definition of a good solvency ratio isn’t set in stone.

Instead, you should interpret a solvency ratio within the context of:

  • Changes over time: Seek trends over a consecutive period of quarters or years.
  • Company goals: As a company works towards achieving specific goals, a solvency ratio may have no change, or, alternatively, experience a dramatic change.
  • Comparables and industry: The range of values for solvency ratios varies across industries. Compare a company’s solvency ratios against those of comparable companies and industry standards.

What is the difference between solvency and insolvency?

Solvency measures a company’s ability to meet its long-term debts. A company remains solvent as long as the value of all of its resources (assets) is higher than the value of all its debts (liabilities).

Insolvency happens when the total value of debts exceeds the total value of assets. If a company remains insolvent for an extended period, a company may become bankrupt and have to work out a way to settle all of its debts.

What is the difference between solvency and liquidity?

Solvency focuses on a company’s ability to pay long-term debts (those due in more than a year), while liquidity centers on a company’s ability to pay short-term debts (those due in under a year).

Additionally, liquidity refers to a company’s ability to turn its assets into cash. A company with current assets (resources like marketable securities and short-term investments that can be reasonably turned into cash within a year) has more liquidity than another company with non-current assets (resources like real estate that take over a year to turn into cash).

What is an example of the solvency ratio in use?

Let’s compare the solvency of two fintech companies, Paypal and Square, using the debt-to-assets ratio.

For the fiscal year that ended Dec. 31, 2019, Paypal had a debt-to-assets ratio of 0.67 ($34.40B/$51.33B), and Square, one of 0.62 ($2.83B/$4.55B).

(Source: Paypal’s 2019 Annual Report and Square’s 2019 Annual Report)

All else equal, the similar debt-to-asset ratios of Paypal and Square suggest that both companies have a similar ability to sustain their long-term debts.

What are the limitations of using the solvency ratio?

The main limitation of using solvency ratios is that it doesn’t account for cash flow. All else being equal, a company with steady or increasing cash inflows is more capable of handling an increase in long-term debt than a company with decreasing cash inflows. Analysts often supplement solvency ratios with an analysis of the cash flow statement — a financial statement showing cash inflows and outflows.

Another limitation of using solvency ratios is that companies with a significant competitive advantage (something that gives a business a leg up over the competition like a patent) or barrier to entry (something that makes it very hard for a new business to enter the market like an oligopoly) may be able to sustain a higher level of debt.

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The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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