What are the Advantages and Disadvantages of Solvency Ratio?

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 about 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?

A company is deemed financially strong if the value of its total assets is higher than the value of its total liabilities. Liabilities, in most cases, means the debt the company has taken for running the operations of the company, which it has a legal obligation to repay with interest. When a company is a solvent, it means that it has enough assets and cash to pay off the liabilities with interest without hindering the profitability by a hefty margin.

If the company is struggling to earn revenue, there won’t be good profits, and the company may default on the loan repayment. When that happens, the company goes into bankruptcy, a point where selling all the assets will not generate enough cash to pay off the liabilities.

The solvency ratio aims to calculate the above scenario where it measures the assets and liabilities of the company to give understand the solvency of the company. It measures its cash flow against all the outstanding liabilities to understand whether the company has enough cash to repay them in the long run.

Unlike liquidity ratios which only measures the cash flow against short-term liabilities, the solvency ratio measures the cash flow against both the long and short term liabilities. Solvency ratios vary from one industry to another and should not be compared between companies belonging to different industries. With solvency ratios, experts compare companies with their competitors within the same industry to better understand the solvency prospects.

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%

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 account 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 prospect of a company. However, the presence of multiple types results in complicating the process.

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 (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 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.

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.