Solvency Ratio: Types, Advantages and Disadvantages

The solvency ratio is a financial metric used to assess a company’s ability to meet its long-term debt obligations.

Solvency ratio offers insight into the financial health and stability of a company by comparing its total assets to its total liabilities.

Table of Contents

• What is solvency ratio?
• Types of solvency ratios
• Advantages
• Disadvantages 

What is Solvency Ratio?

A solvency ratio is a metric that assesses a business’ ability to fulfilling long-term debt requirements. Business owners use this ratio to show if the company has the sufficient cash flow to fulfill its long-term liabilities. Overall, a good solvency ratio measures a company’s financial health. 

A company has the ability to meet its long-term financial obligations. Potential lenders and bond investors also evaluate a company’s creditworthiness using different solvency ratios. In comparison with the liquidity ratio, solvency ratios have a long-term outlook. 

What does the solvency ratio indicate?

If an organization has a solvency ratio greater than 100%, it is considered to be financially healthy. When the solvency ratio goes below 100%, then it indicates that a company may be struggling to meet its long-term liabilities.

Since solvency ratio is expressed as a percentage and is measures the proportion of a company’s assets covering its liabilities. Solvency ratio of 100% indicates that the company’s assets match its liabilities exactly. A solvency ratio above 100% is healthy and indicates that company’s assets are more than its liabilities. The solvency ratio below 100% suggests that liabilities are more than its assets. 

Suppose there is a company called ABC Limited owing assets worth rupees 10,000,000 and liabilities worth 6,00,000. By using the formula, we will learn that the solvency ratio is 167%. This means that for every asset worth rupees 1.67 there are liabilities worth rupees 1. Since the company has more assets than liabilities, it indicates a financially strong position. 

Types of Solvency Ratios

There are mainly four types of solvency ratios:

1. Interest Coverage Ratio

Interest Coverage Ratio is a financial metric that assesses the ability of a company to manage its interest expenses. It indicates the ease with which a company can pay interest on its outstanding debt. 

This ratio compares a company’s earnings before interest and taxes to interest expenses. This financial ratio is evaluated by dividing the EBIT of the company by the interest payment due on debts for an accounting period. 

2. Debt-to-Assets Ratio

It is a measure of the total debt of a company to its total assets. This ratio measures the company’s leverage and indicates how much a company is funded by debt versus assets. It also reflects the ability of a company to pay off its debts with available assets. When the debt-to-asset ratio is above 1.0 then the company is heavily funded by debt and the company is having a difficult time in meeting its obligations. 

3. Equity Ratio

Also known as the proprietary ratio, the equity ratio is a type of solvency ratio that determines the contribution of proprietors to the total assets of a business. This ratio indicates the relationship between the proprietor’s funds and net assets/capital. It uses investment in assets and the amount of equity. This helps in determining how well the company manages its debts and how well it funds its asset requirements.

4. Debt-to-Equity ratio

It represents the amount of debt that a company owns as compared to its assets. The Debt-to-Equity ratio is calculated by dividing the total debt of a company by its shareholder equity. A higher D/E ratio represents that the company has difficulty covering its liabilities. If the company’s debt to capital is more than 1, it represents a higher ratio. 

This ratio represents a higher Return on Equity (ROE) as the assets increase and equities decrease. If the company can easily pay its debt, then the debt-to-equity ratio is good which in turn makes it a good debt. These are the ratios below 1 are good debt-equity ratios. When the shares of companies with bad D/E ratios. 

Advantages of Solvency Ratios 

The following points explain the advantages of solvency ratios:

• Investors can compare historical solvency ratios with the current solvency ratio to assess the company’s performance. 
• It helps investors to make an informed decision before investing funds in the company. By calculating the ratio, you can avoid the risks of bearing loss by investing in firms that are financially not doing well. 
• This ratio helps in periodically analyzing a company’s financial well-being. This allows you to assess whether a company is capable of paying off its debts in the long run. 
• Investors can measure the total value of assets against the total value of liabilities. This shows the amount of cash that the company contains for meeting financial obligations.

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Disadvantages of Solvency Ratio

The following points explain the disadvantages of solvency ratios:

• Besides debt, there are many other factors due to which the company might be undergoing bankruptcy. In the case of solvency ratios, only the debt of the company is considered.
• The solvency ratio does not help a company in acquiring new funds. To do so, other ratios must be considered to determine the fair solvency of a company. 
• You cannot properly assess the financial health of your company since the method to calculate the solvency ratio varies between companies. This variation is due to the use of different formulas as well as procedures for calculating the ratio. This complicates the assessment of companies.