As the owner of a small business, you are the one responsible for ensuring the company can meet its financial obligations now and into the future. One tool that can help you do that is known as a solvency ratio.
A key part of a financial analysis, a company’s solvency ratio determines whether it has sufficient cash flow to manage its debts as they come due. The following formula is used to track a business’ solvency ratio, which is usually expressed as a percentage:
For the purpose of calculating solvency, net income includes all cash and holdings that can be easily liquidated. Overall, companies with higher solvency ratios are viewed as more likely to meet their financial obligations, whereas those with lower scores are seen as posing a greater risk to banks and creditors. Although a good solvency ratio varies based on the industry in question, a company with a ratio at or above 20% is generally considered healthy. Solvency ratios are sometimes referred to as “leverage ratios.”
It’s important to realize that solvency ratios aren’t the same as liquidity ratios. Whereas liquidity ratios refer to the capacity of a company to handle short-term liabilities, solvency measures the ability to pay long-term debts.
In the long run, keeping an eye on your solvency ratio can help prevent the company from going bankrupt because of rising debt levels. In other words, knowing your ratio should help you determine when you can and can’t handle additional debt.
The Importance of Calculating Solvency
Periodically checking your business’ solvency ratios can help ensure your company’s fiscal health. In addition to helping businesses evaluate their capital structures, solvency ratios may assist owners in determining whether internal and external equities must be redistributed. Furthermore, solvency ratios may affect your decision to take on more debt down the line. Businesses with excessive debt may struggle to manage cash flow or deal with rising interest levels.
Not only does calculating solvency help companies make important financial decisions and ensure future profitability, but it also reassures creditors and shareholders that your business can pay its debts.
Lenders want to know that your company can pay back the loan principle as well as the interest that accumulates. A poor solvency ratio may suggest that your company will be unable to meet its obligations in the long term.
A good solvency ratio varies by industry, so it’s important to compare your numbers with those of your competitors. Because businesses in some industries are able to survive with solvency ratios that would be considered unhealthy in others, companies should refrain from scrutinizing these numbers in a vacuum. Historically, technology companies tend to boast higher solvency ratios than those in debt-heavy industries, such as utilities.
Fortunately, most companies can take steps to improve their solvency ratios and boost profitability in the long term. Along with selling assets to reduce overall debt, a company may opt to reorganize its business structure, increase owner equity or reinvest money and assets in the business. And of course, struggling businesses should try to avoid taking on new debts until their solvency ratios improve. Finally, companies should also strive to improve sales, as this will ultimately boost both profitability and solvency.
Types of Solvency Ratios
There are different types of solvency ratios that you can use to track different elements of your finances. Here are some of the most common types of solvency ratios that companies track on a regular basis:
This ratio is a measure of total debt as compared to shareholder equity. As an equation, you take your business’ total liabilities and divide them by your shareholders’ equity.
Whereas a general high solvency ratio tends to indicate that a company is fiscally sound, a high debt-to-equity ratio suggests that the company over-utilized debt to bankroll its growth. As interest levels continue to climb, companies may suffer from volatile earnings. To prevent insolvency, business owners must focus on deferring costs, reducing debt and boosting overall profits.
This refers to the ratio of long-term and short-term liabilities compared to total holdings. As an equation, it is expressed as your business’ short- and long-term liabilities divided 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 take into account the degree of leverage. While some liabilities, such as supplier costs and employee bonuses, may be negotiable, companies with high total-debt-to-total-assets have higher leverages and, as a result, lower flexibility. Because of this, businesses should strive to raise the value of current assets or reduce their debt levels moving forward.
These ratios measure a company’s ability to keep up with interest payments, which rise along with outstanding debt. As a business owner, you can calculate interest-coverage ratio by dividing earnings before interest and tax (EBIT) by interest expenses.
Typically, a company with an interest-coverage ratio of 1.5 or less is viewed as financially unstable and may struggle to secure loans from banks and other lenders. To boost your interest-coverage ratio, strive to reduce debt and boost overall profits.
Solvency ratios don’t just affect your ability to get loans from banks and creditors, but they also forecast your company’s health in the coming years. By calculating your business’ ratios often, you can ensure that you have the most accurate and thorough understanding of your finances, which will keep you from becoming insolvent.
For more background on essential financial ratios, see our article on seven accounting formulas every business should know.