Solvency ratio measures the company’s ability to pay its long term debt obligations. Solvency ratio provides information related to the adequacy of cash flow and earnings to cover interest, other fixed costs and principal payments as they come due.
In other words, solvency ratio measures the size of a company’s profitability and compares it to its obligations to assess the company’s long term ability to meet its financial obligation such as repaying debts.
In order to interpret the solvency of a company you have to first understand the financial structure of the company. Amount of debt in the company’s capital structure is very important in order to assess the company’s risk and return characteristics.
Solvency ratio is used by prospective lenders to evaluate a company’s creditworthiness. It’s a metric used to assess whether a company can stay solvent in the long run. This means solvency ratio measures the company’s repayment ability for its long term debt and the interest on that debt.
Why financial leverage is important for equity holders
Analysts generally look at two types of leverages while analysing a company. They are operating leverage and financial leverage.
Operating leverage results from the use of fixed expenses in conducting the company’s business. Higher the fixed costs, higher the operating leverage.
The effect of change in operating income impacts the operating leverage. Profitable companies may use operating leverage as rise in revenue will increase operating profit at a faster rate so that the company can have enough profit after taking out fixed costs.
Financial leverage means presence of debt or fixed charge bearing sources in the capital structure of the company. This means it’s the leverage created with the help of a debt component.
While taking debt to the balance sheet, interest payments become fixed finance costs. As a result of interest payments, a given percentage change in earning before interest and tax (EBIT) results in a larger percentage change in profit before tax (PBT).
Companies use debt to fund its expansion plan if internal cash flow is not sufficient to do that. However, in a downturn economy, when revenue comes down drastically due to market conditions and variable costs go up, the impact of financial leverage on profitability can severely damage the company’s profitability. The company may become bankrupt depending on the level of debt used in the balance sheet.
Therefore a higher level of debt increases the risk of default due to higher level of borrowing costs for the company.
Analysts pay importance to operating and financial leverage based on the type of industry and in comparison to immediate competitors.
Here are the two type of solvency ratios used by analyst to analyse financial conditions of a company;
- Debt ratio
- Coverage ratio
Debt ratio measures the amount of debt in a company’s capital structure in comparison to equity capital. Coverage ratios measure the company’s ability to cover its debt payments.
|Debt to asset ratio / total debt ratio
|Total debt / total assets
|Debt to capital ratio
|Total debt / (total debt + equity capital)
|Debt to equity ratio
|Total debt / total shareholder’s capital
|Financial leverage ratio
|Average total assets / average total equity
|EBIT / interest payments
|Fixed charge coverage
|(EBIT + Lease payments) / (interest payments + lease payments)
High or low, which solvency ratio is better?
Key solvency ratios used by analysts are the debt to assets, debt to equity, interest coverage and fixed coverage ratios.
Debt to assets
Debt to asset ratio measures the percentage of total assets financed with debt. Debt to asset helps analysts to measure leverage on the balance sheet to fund company’s assets.
A debt to asset ratio of 0.50 or 50% indicates that the company has funded 50% of its total assets with debt. Higher percentage indicates weaker solvency as it has a higher impact on profitability.
A higher debt to asset ratio above 1 indicates that a company is significantly funded by debt and may have difficulty in meeting its obligation.
Percentage of debt in a company’s capital is measured by debt to capital ratio. A high debt to capital ratio indicates higher financial risk and weaker solvency.
Debt to equity
Debt to equity ratio measures the level of debt used in companies capital relative to equity capital. Debt to equity ratio (D/E) is considered as a fundamental indicator of the amount of leverage a company is using. Debt generally refers to long term debt and equity refers to shareholder’s equity.
A ratio of 1 indicates an equal amount of debt and equity is used to fund the company. A higher debt to equity ratio indicates weaker solvency.
Financial leverage ratio measures the amount of total assets funded by equity capital.
For example, a value of 2 for financial leverage ratio means that each 1 rupee of equity supports 2 rupees of total assets. Higher financial leverage ratio indicates a higher amount of debt and other liabilities are used to finance assets.
In general, debt to eqity and interest coverage ratios are popularly referred as solvency ratios.
Interest coverage ratio
Interest coverage is calculated by taking a company’s earnings before interest and taxes (EBIT) and dividing it by the total interest expenses from long term debt.
Interest coverage ratio measures the number of times a company’s earnings before interest and tax could cover its interest payments.
If the interest coverage ratio is high, then it indicates stronger solvency by giving assurance that the company can service its debt cost from operating earnings.
Fixed coverage ratio
Fixed charge coverage ratio measures the number of times a company’s earnings before interest, taxes and lease payments can cover the company’s interest and lease payments. A higher fixed charge coverage ratio indicates higher solvency, giving assurance that the company can service its debt from the company’s normal earnings.
Solvency ratio can vary from industry to industry. Therefore, you should compare solvency ratio with its immediate competitors in the same industry.
A higher solvency ratio indicates financial strength. In contrast, a lower ratio signals financial weakness.
Solvency ratios vs. liquidity ratios
Both solvency and liquidity ratios are used to indicate health of a company. The main difference is that liquidity ratio measures how the company can meet its short term obligations whereas solvency ratios focus on long term outlook, which means whether the company can meet its finance cost in the long term.
The current ratio and quick ratio measure a company’s ability to cover short-term liabilities with liquid assets. Liquid assets are those assets which have maturities of a year or less, it include cash and cash equivalents, marketable securities, and accounts receivable.
In solvency ratios we look at all assets of the company which includes non-current and current assets. In liquidity ratios, we look at the most liquid assets which can easily be converted to cash such as cash and marketable securities.
You can’t base your decision based on solvency ratios. It’s important to look at a variety of ratios to measure the financial health of a company. Further you need to compare these ratios and financial data with peers, particularly with a strong company in its industry to measure the financial health and efficiency.