What are the Advantages and Disadvantages of Solvency Ratio?

Last Updated: 18 Nov 2024

Professional Investors use and analyse a host of financial metrics to ensure their investment decisions are profitable. One such widely used metric is the Solvency Ratio. It allows investors to cut down investment risk and ensure they are investing in a stock that is more than likely to appreciate in price. In this blog, you will learn about the solvency ratio and the advantages and disadvantages of the solvency ratio.

What is the Solvency Ratio?

A company’s solvency ratio is a financial measure of its actual cash flow to provide a comprehensive idea of its ability to repay its long-term debt and meet its other financial obligations. The idea behind analysing a company’s solvency ratio is to assess its capacity to stay afloat and not go bankrupt because of crumbling revenue and profits.

As companies need revenues and profits to pay off their debt in the long term, solvency ratios are important to analyse whether the company is earning enough to be solvent. If a company’s solvency ratio is healthy, it means that the company can repay its long-term debt along with the interest payments. The higher the solvency ratio, the better the company’s long-term financial prospects.

How do Solvency Ratios work?

Solvency ratios determine the ability of a firm to pay its long-term obligations, thus reflecting the general financial health of the firm. The ratios are calculated either by determining the total assets against the total liabilities or by how much cash flow is generated against liabilities. Commonly known solvency ratios are the debt-to-equity ratio and the interest coverage ratio.

A high solvency ratio suggests that the company has enough assets or earnings to pay off debts, thus showing that it is financially strong. A low solvency ratio may reflect some trouble in managing long-term obligations, which might prevent investors and creditors from getting into the business.

Since the solvency ratio offers insight into debt levels and cash flow, stakeholders use these ratios to analyse whether the company is stable enough for long-term operations. Thus, it is used for proper decision-making about investment or lending.

How to calculate Solvency Ratio?

There are numerous ways through which a company’s solvency ratio. However, the main formula for calculation is listed below:

Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)

Since the denominator comprises liabilities against the entire cash flow in the numerator, the solvency ratio is the most comprehensive determiner of a company’s solvency.

For example, if a company has a net income of Rs 50,000, depreciation of Rs 10,000, short-term liabilities of 75,000, and long-term liabilities of Rs 1,50,000. Then, the solvency ratio will be:

Solvency Ratio: (50,000+10,000)/75,000+1,50,000) = 0.2666 I.e. 0.2666 x 100 = 26.6%

Types of Solvency Ratios

The various types of solvency ratios are as follows:

• Interest Coverage Ratio: The ratio measures the number of times a company can meet its current interest payments using the available earnings. The formula for the Interest Coverage Ratio is Earnings before interest and taxes is: (EBIT)/ Interest Expenses.
• Debt-to-Asset Ratio: The ratio measures a company’s total debt against the total assets. It presents a company’s leverage and indicates the portion of the company’s finances that is funded by debt versus its assets. The formula for debt-to-Asset ratio is Total Debt / Total Assets.
• Equity Ratio: The ratio, also called the equity-to-assets ratio, depicts the portion of the company’s finances that is funded by equities. The higher the ratio, the healthier the company financially. The formula for the equity ratio is Total Shareholder Equity / Total Assets.
• Debt-to-Equity (D/E) Ratio: The ratio is identical to the debt-to-assets ratio and indicates how much the company is funded through debt. The lower the ratio, the lower the chances of default. The formula for the debt-to-equity ratio is Debt Outstanding / Equity.

Advantages and Disadvantages of Solvency Ratio

For an investor or an analyst, solvency ratios are one of the most important metrics to analyse a company’s financial health. Hence, it is vital to understand the advantages and disadvantages of solvency ratios. This helps them be better equipped to make informed financial decisions. The advantages and disadvantages of solvency ratios are as follows:

Advantages of Solvency Ratio:

• Long-term financial obligations: Solvency ratios allow investors and analysts to measure a company’s financial health based on its ability to fulfil its long-term financial obligations. In the process, it measures the total value of the assets against the total value of the liabilities to present how much cash the company has to meet the financial obligation.
• Performance analysis: A company’s cash flow and solvency factor is a direct metric that calculates the business performance of a company. Solvency ratios measure the capacity of the company to earn revenues to pay off debt, which analysts and investors widely use to analyse the company’s performance. These investors compare the historical solvency ratios with the present to get an idea of how the company is performing.
• Helps in Investing: Investors use solvency ratios to make informed investment decisions as it cuts the risk of losses by a huge margin. If a company’s solvency ratio is high, it means that the company will effectively pay off its debt, which creates a positive sentiment around investors and increases the share price.

Disadvantages of Solvency Ratio:

• Irrational Results: Solvency ratios only look at the debt of the company to measure solvency. A company may have a low debt amount; however, due to increasing accounts payable and bad cash management, the company may be headed towards bankruptcy. Although the company’s financial health is bad, the solvency ratio will not showcase it in the results.
• New Funding: The calculation of the solvency ratio does not factor in a company’s capability to acquire new funds through means such as stock or funds. Hence, the solvency ratio may change after some time and should be used alongside other ratios to determine the fair solvency of the company.
• Extensive Process: There are numerous types of solvency ratios that investors can use to determine the solvency prospects of a company. However, the presence of multiple types results in complicating the process.

Conclusion

The solvency ratio is one of the most important ratios used by investors to identify undervalued stocks that increase in price over time. The solvency ratio provides a comprehensive understanding of a company’s solvency and its ability to generate enough cash to pay off its long-term debt. As an investor, you can use solvency ratios to analyse a company in the process of investing.

Frequently Asked Questions

What are good solvency ratios?

Solvency ratios differ for companies that belong to different industries. However, as a general rule of thumb, a company is deemed to have a good solvency ratio if the ratio is above 20%, irrespective of the industry. The lower the solvency ratio, the poorer the company’s financial health.

What is the importance of the Solvency Ratio?

The solvency ratio calculates a company’s ability to pay off its long term debt and meet other long term financial obligations. It allows analysts and investors to understand how solvent a company is and then make informed financial decisions. The higher the solvency ratio, the higher the chances of an increase in the company’s share price.

What does a high solvency ratio indicate?

A high solvency ratio represents a company’s financial capability to pay off its long-term obligations. It symbolises a sound balance sheet, meaning the company holds enough assets to pay the liabilities. It gives potential investors and creditors the understanding that the company has a relatively low risk of default, hence making it a low-risk investment.

Can a company with a low solvency ratio secure financing or credit?

A low solvency ratio makes it relatively hard for a company to borrow or get credit from financiers. Lenders and investors view a low solvency ratio as a sign of financial instability and as being more risky. This makes lenders increase interest levels or refuse to lend a big amount.

What is a 30% solvency ratio?

A 30% solvency ratio means that the total assets of a company are 30% of its total liabilities. It has a relatively low capacity to cover long-term obligations, which may indicate financial stress. Companies with such a ratio may face difficulties in obtaining credit and may need to improve their financial health.