April 6, 2020 Financial Management en_US Understanding your company's solvency will give you a clear picture of its financial health and allow you to course correct for a brighter business future. https://quickbooks.intuit.com/cas/dam/IMAGE/A3kRexfKa/fb359759b39d48187192155b0ce0014c.png https://quickbooks.intuit.com/r/financial-management/understanding-solvency-ratios/ What solvency is and how it solves your financial woes
Financial Management

What solvency is and how it solves your financial woes

By John Shieldsmith April 6, 2020

As a small business owner, you have to manage expenses, finances, taxes, and debts—all while trying to grow your business. But when it comes to debt, tools like the solvency ratio can help you determine how much your business can manage.

A key part of financial analysis, a company’s solvency ratio measures its ability to pay long-term debts. Calculate your business’s solvency ratio by first adding your net income after taxes and your non-cash expenses. Then divide that number by your liabilities to get your solvency ratio, expressed as a percentage.

(Net income after tax + non-cash expenses) ÷ all liabilities = solvency ratio

Overall, the higher a company’s solvency ratio, the more likely it is to meet its financial obligations. Companies with lower scores are said to pose a higher risk to banks and creditors. Although a good solvency ratio varies by industry, a company with a rate of 0.5 is considered healthy.

The importance of calculating solvency ratios

Periodically checking your business’s solvency ratio can help ensure your company’s financial health. In addition to helping businesses evaluate their capital structures, solvency ratios may assist business owners in determining whether they must redistribute internal and external equities.

Solvency ratios may affect your decision to take on more debt down the line. So calculating solvency helps companies make critical financial decisions and ensure future profitability. And they reassure creditors and shareholders that your business can pay its debts.

Lenders want to know that your company can pay back the loan principal and the interest that accrues. A poor solvency ratio may suggest your company won’t meet its obligations in the long term.

A good solvency ratio varies by industry, so it’s important to compare your numbers with your competitors’ numbers. Some businesses can manage debts with solvency ratios that would be considered unhealthy for another business. For example, technology companies tend to have higher solvency ratios than utility companies.

3 types of solvency ratios

1. Debt-to-equity ratios

This ratio is a measure of total debt, compared to shareholder equity. To calculate your debt-to-equity ratio, divide your business’s total liabilities by your shareholders’ equity. In general, a high solvency ratio tends to indicate that a company is sound. But a high debt-to-equity ratio suggests that the company over-utilized debt to grow.

2. Total-debt-to-total-asset ratios

This refers to the ratio of long-term and short-term liabilities, compared to total holdings. To calculate total-debt-to-total-asset ratios, divide your business’s short- and long-term liabilities by its total assets. As a company’s total-debt-to-total-assets ratio increases, it poses a greater financial risk to banks and creditors.

When calculating total-debt-to-total-assets, it’s important to consider leverage. Generally, financial leverage refers to a borrowed amount that gives your business more purchasing power. Borrowed amounts, in this case, might be loans you use to buy new equipment or invest in your company.

Some liabilities, such as supplier costs and employee bonuses, may be negotiable. But companies with high total-debt-to-total-assets have higher leverages and lower flexibility as a result. In this case, businesses should strive to raise the value of current assets or reduce their debts moving forward.

3. Interest-coverage ratios

These ratios measure a company’s ability to keep up with interest payments, which rise along with outstanding debt. Calculate your business’s interest-coverage ratio by dividing earnings before interest and tax (EBIT) by interest expenses.

Typically, companies with interest-coverage rates of 1.5 or less may struggle to secure loans from banks and other lenders. To boost your interest-coverage ratio, reduce your debts and boost your overall profits.

How to improve your business’s solvency ratio

1. Run a sales campaign

If your ratio isn’t where you want it, conduct a sales campaign to try boosting your sales. Even a temporary boost can help offset debt and make your ratio more appealing to investors. If you’re looking for investors, you might push for sales ahead of time to show what your company is capable of improving solvency.

2. Issue stock

If yours is a traded company, you may issue new shares to boost your cash flow. Businesses can use this money for short-term obligations and debt. And it can help boost your solvency and get you out of any immediate high-risk debt. This can help you focus on long-term obligations as well, as you’ll have freed up income with that debt out of the way. If you decide to go this route, make sure you don’t issue too many stocks and devalue them. There’s a delicate balance to maintain, so speak with a financial advisor before taking action.

3. Avoid new debt

Avoid taking on any new debt while you try to improve your solvency ratio. Instead, apply for grants, forgivable loans, and other forms of financial relief that won’t require interest or debt.

4. Reevaluate operating expenses

Go over your current operating expenses and see where you can cut back. You may be using certain vendors who are outside of your budget, for example. Reevaluating operating expenses can improve your debt-to-income ratio and increase your operating income.

5. Look for bulk discounts

If you’ve been with your vendors for a while, try reaching out to them for bulk discounts. In some cases, vendors may prefer to keep their current customers by offering bulk discounts. Just like reevaluating expenses, bulk discounts can help increase your operating income.

6. Increase owner equity

Depending on your finances, you may consider buying into your company more and increasing your owner’s equity. This can help offset debt obligations, sway the ratio in your favor, and make your company more solvent.

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