A solvency ratio helps predict a company’s future health and potential, specifically measuring how an organization can effectively pay off its debts while remaining operational. This insight is typically leveraged by outside actors—lenders, suppliers, investors—to determine how profitable a relationship might be with your business.
In this blog, we’ll examine what a solvency ratio is, the various types, how to calculate them, and what these metrics can do to benefit your business.
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What is a solvency ratio, and why is measuring solvency important for your business?
In more detail, solvency ratios—sometimes called leverage ratios—reflect a class of metrics that map out whether or not an organization’s current and expected cash flow is sufficient to meet its long-term liabilities. Focusing on short- and long-term cash flows alongside short- and long-term debts, these calculations help predict the likelihood that a business can pay its bills over the next year and several years.
Typically, a higher ratio identifies a healthy business, while lower scores might indicate a default or liquidation in the company’s future. Lenders and suppliers rely on this predictive nature to determine whether or not they should extend credit and what terms would be appropriate. Similarly, potential investors and shareholders can factor these numbers into their calculations of how safe their funds will be with a given business.
This predictive function can also help businesses evaluate the efficiency of their internal processes and policies, letting them measure the performance of various adjustments to existing operations. Through these evaluative efforts, a company can:
- Create opportunities for new investment and growth
- Forecast future profitability
- Flag and resolve cash flow problems
- Set attainable budgets based on real-world data
- Track the predicted interest costs of long-term debts
What is the difference between solvency ratios and liquidity ratios?
Remarkably similar to solvency ratios, liquidity ratios also reflect a class of metrics used to measure the health of a business by projecting its ability to pay off debts. However, liquidity ratios specifically focus on how quickly these debts can be paid off and exclusively consider short-term debts—those that need to be resolved in the next 12 months.
Types of solvency ratios and their formulas
There are four traditional types of solvency ratios, each granting a nuanced insight into your company’s long-term health and ability to handle debts. So, suppose you want to calculate your solvency ratio. In that case, you’ll first need to decide which calculation best serves your purpose or which processes you wish to factor into your evaluation. Fortunately, whatever option you choose, the calculations are very straightforward, and the relevant data that you’ll need can typically be found on your regular financial statements and reports.
Interest coverage ratio (ICR)
This ratio identifies the number of times your company’s profits could be used to cover the current interest payments for all your outstanding debts. So, a higher score suggests that your day-to-day operations generate enough income to cover your obligations.
Interest coverage ratio formula
Interest Coverage Ratio = Earnings Before Interest and Tax ÷ Current Interest
Interest coverage ratio example
Science education firm Fantastico Co. wanted to obtain a loan to fund its model rocket product line update. But before reaching out to lenders, the business chose to confirm that its current profitability was sufficient to cover interest payments for its existing debts, let alone any new ones. After an internal analysis, Fantastico determined that its available earnings before interest and tax (EBIT) was $1.2 million for the past six months, while its current interest payments totaled $1.1 million for the same period. These findings yielded an interest coverage ratio of 1.09, and given the lower score, Fantastico chose to hold off on its rocket updates to focus on boosting profitability.
Interest Coverage Ratio = $1.2 million ÷ $1.1 million = 1.09
As its name would suggest, your debt-to-asset ratio will let you know how much of your current assets were funded by debt. For this metric, a lower score is preferable as it indicates that you have more than sufficient resources in hand to cover everything you owe.
Debt-to-asset ratio formula
Debt-to-Asset Ratio = Total Debt ÷ Total Assets
Debt-to-asset ratio example
After navigating a surprisingly turbulent couple of years in the consumer market, the owners of Matchstick Hot Sauce Inc. were concerned that the business might be carrying too much debt to sustain long-term operations. So, the company wanted to determine its debt-to-asset ratio to gain clearer insight into how much of its operations were being run by borrowed money. After determining that its total existing debts were valued at $300,000 while its current assets totaled an impressive $700,000, Matchstick realized that it had a ratio of .43—a rather attractive result.
Debt-to-Asset Ratio = $300,000 ÷ $700,000 = .43
Your equity ratio identifies the relationship between owner funds (e.g., shareholder equity) for your business and your total assets. A higher ratio, therefore, indicates that a majority portion of your assets were financed by shareholder money rather than debt.
Equity ratio formula
Equity ratio = Total shareholder equity ÷ Total assets
Equity ratio example
The executives of Clobberin’ Time Boxing (CTB) weren’t sure if buying up regional competitor Yancy Street Athletics was a good idea or a bad one. Hoping to gain more insight into the health of Yancy, the financial team at CTB examined the balance sheet of the smaller boxing chain, noting that the company’s shareholder equity totaled $350,000 while its assets came in at $900,000. With an equity ratio of .39, Yancy relies more on debt than equity—a fact that CTB intends to leverage during negotiations.
Equity ratio = $350,000 ÷ $900,000 = .39
To determine how heavily your business has been leveraged to fund operations, you’ll want to look at your debt-to-equity ratio. Essentially, this metric identifies the percentage of financing creditors contributed compared to investors. So the higher the number, the more debt you have on the books and the less funds you’ll have available for shareholders if you liquidate.
Debt-to-Equity Ratio = Total Debt ÷ Total Shareholder Equity
As part of its routine financial review efforts, Concealed Cosmetics monitors its overall solvency. And knowing that it had recently covered some of its liabilities during a low-cash period with a series of loans, accounting staff, and executives wanted to examine the firm’s debt-to-equity ratio. When reporting, the business was sitting on $950,000 in debt while its total shareholder equity reached $1.2 million. Pleased with its score of .79, Concealed Cosmetics feels confident about the future.
Debt-to-Equity Ratio = $950,000 ÷ $1.2 million = .79
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What is a good solvency ratio?
Before discussing any targets, it’s important to note that desirable solvency ratios vary considerably by industry and region. For example, businesses that need to outlay large, up-front capital investments before netting profits—such as multi-million dollar aircraft purchases made by an airline—will always carry higher levels of debt than market segments that can quickly convert resources to cash.
With that clarified, your target ratio will also vary depending on which calculation you are performing, but generally you’ll want to consider:
- For interest coverage ratios: seek a score of 1.5 or higher—anything below suggests that you might struggle to meet your interest obligations
- For debt-to-asset ratios: go as low as possible, preferably between .3 and .6; a score of 1.0 means your assets are equal to your debts
- For equity ratios: aim for a ratio close to .5—score higher and you’ll likely be considered conservative, while scoring lower will indicate that you are leveraged
- For debt-to-equity ratios: keep your score well below 2.0; while target ratios vary dramatically across industries in this category, a score of 2.0 is widely considered too high by all segments
Since these figures only represent a snapshot of your finances, you should only consider solvency ratios in conjunction with other metrics and reports to gain a fuller, richer understanding of your company’s health. It’s also recommended that you track the same ratio over a period of time to identify trends and determine the direction your business is going.
Limitations of solvency ratios
While these metrics might be useful in flagging debt-related financial issues, they provide no insight into other potential challenges that a business might be experiencing, such as poor cash management or inefficient accounts payable processes—either of which can easily threaten long-term viability. As a result, the company in question might have an amazing solvency ratio but still be sprinting towards bankruptcy.
At the same time, even though these metrics can indicate a solvency problem, they can’t identify what might be causing the issue, limiting their value for diagnostic purposes. They also fail to account for any measures that the business might take in the future to mitigate its current shortcomings—such as attaining new funding sources or limiting the amount of debt needed to keep things running.
Typically, you can develop strategies or employ technologies to cut operating costs and bolster your cash flow management efforts. For instance, a robust, automated accounting platform can deliver more granular control over when and how you pay your bills, allowing you to leverage your available cash better and reduce your reliance on debt.
Finally, there is a surprising amount of variability within solvency ratios. There are traditionally four unique types (as described above), but the naming, proscribed formulas, and even the nature of these calculations can vary widely between businesses and markets. And this variability will complicate—and potentially invalidate—any comparisons you make between your organization and other companies or industry standards.
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