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Let’s start with an example. Raj owns a small-scale textile company in Mumbai, recently honoured with the “Business Innovator of the Year” by a leading magazine. This recognition led a prominent retail chain to place an order worth ₹3.5 crores for his textiles.
Overjoyed yet pragmatic, Raj understood he needed a substantial loan to cover materials and labour costs. Unfortunately, his loan application was declined. In a meeting with the bank’s loan officer to understand how to improve his financial standing, Raj learns that the key issue was his company’s solvency.
What is the solvency ratio? It is a company’s ability to fulfil its long-term financial obligations. Raj was initially confused since his company’s liquidity ratios were in good standing.
However, the bank officer explained that liquidity are short-term solvency ratios, that reflect a company’s immediate obligations, while solvency focuses on the long-term. If you want to gain a better understanding of solvency ratios and the process of calculating it, continue reading.
How to calculate solvency ratio?
The solvency ratio formula is:
Solvency Ratio = (Net Income + Depreciation) / Total Liabilities
A higher solvency ratio indicates a company’s strong capability to cover both its short-term and long-term liabilities with its earnings. Conversely, a low solvency ratio signals potential difficulties in fulfilling future financial commitments.
The benchmark for a healthy solvency ratio varies across different sectors, yet generally, a ratio above 1 is deemed favourable. This implies that the company generates a substantial profit for every rupee of liability it holds. To enhance its solvency ratio, a firm can either boost its net income or reduce its total liabilities.
Solvency ratio example:
Let’s consider Raj’s situation as an example to understand the solvency ratio and its calculation to understand where it stands in terms of long-term financial health.
For the fiscal year, Raj’s company reported:
| Particulars | Amount (₹) |
| Net income | 1,50,000 |
| Depreciation | 5% |
| Short-term liabilities | 4,00,000 |
| Long-term liabilities | 10,00,000 |
Given these figures, let’s proceed with the calculation:
The company invested ₹10,00,000 in new machinery, and the depreciation rate is 5%.
Depreciation = 5% of ₹10,00,000 = ₹50,000.
Solvency Ratio = (₹1,50,000 + ₹50,000) / (₹4,00,000 + ₹10,00,000)
= ₹2,00,000 / ₹14,00,000
= 0.143 ratio or 14.3%
The long-term solvency ratio is 14.3%. This indicates that for every ₹1 of liability, the company generates only ₹0.14 in net income.
This is the primary reason why Raj’s loan application was initially rejected by the bank. The low ratio indicates that the company may struggle to maintain its operations and investments in the long run without improving its financial health.
Limitations of solvency ratio
The solvency ratio has limits even if it provides information about a company’s financial viability. One significant shortcoming is its inability to consider the company’s potential to raise new capital through equity or debt in the long term. This makes it crucial to combine the solvency ratio with other financial analyses for a fuller picture of a company’s health.
Moreover, solvency ratios don’t differentiate between the timing or quality of assets and liabilities. A company might appear solvent with substantial long-term assets that aren’t readily convertible to cash, potentially misleading about its short-term financial resilience.
Additionally, solvency ratios overlook off-balance sheet items, such as lease obligations, which can profoundly impact a company’s debt repayment capabilities. Lastly, these ratios don’t reflect cash flow –a critical factor for covering operating expenses and preventing debt defaults. Thus, while useful, solvency ratios should be part of a broader financial analysis rather than a standalone measure.
Solvency ratio types
Depending on the assets and liabilities assessed, there are various solvency ratio types that provide distinct insights into a company’s capacity to fulfil long-term commitments.
Debt-to-asset ratio: Indicates a portion of an organisation’s assets are funded by debt. A lower ratio denotes a healthier solvency position because it shows less reliance on debt.
Debt-to-equity ratio: It assesses the amount of a firm’s capital that comes from debt financing. It is computed by dividing total debt (equity plus debt) by total capital. A smaller percentage points to a capital structure that is more cautious.
Debt-to-capital ratio: It evaluates the portion of a company’s capital coming from debt, offering insight into its financial leverage. The formula divides total debt by the sum of debt and equity, indicating the balance between debt and equity financing.
Interest coverage ratio: This ratio evaluates the ability of a business to pay debt interest. Stronger solvency is suggested by a higher ratio, which indicates a greater ability to pay interest payments.
Bottomline
Solvency ratios are an important tool for assessing a firm’s long-term financial health, but it’s best to use them in conjunction with other financial indicators. These ratios offer a focused perspective on a firm’s ability to meet future obligations but do not paint a complete picture.
A thorough evaluation must take a comprehensive approach that takes into account elements such as cash flow, off-balance sheet activities, and the ability to generate money. Nevertheless, solvency ratios continue to be a crucial tool for management, creditors, and investors to assess a company’s financial soundness and make informed decisions.
FAQs
The solvency ratio evaluates a company’s capability to meet its long-term financial commitments. It is calculated by comparing a firm’s total assets to its total liabilities, providing insights into the business’s financial stability. A higher ratio suggests the company can cover its long-term debts more effectively, indicating better financial health. Conversely, a lower ratio may indicate potential difficulties in meeting obligations, representing a higher risk.
If a solvency ratio is 1, it means a company’s total assets are exactly equal to its total liabilities. This means the company has just enough assets to cover its liabilities but no surplus. While technically solvent, a solvency ratio of 1 suggests a precarious financial position with no buffer against future liabilities or downturns. Such a company may struggle with limited financial flexibility and may face challenges in meeting future obligations or securing additional financing if needed.
The solvency ratio is calculated by dividing a company’s net income plus depreciation by its total liabilities. It measures the company’s ability to meet its long-term financial commitments. To calculate, you add net income (profit after taxes) to depreciation (a non-cash expense) to get the numerator. Then, divide this by the company’s total liabilities, including both short-term and long-term debts. The formula is: Solvency Ratio = (Net Income + Depreciation) / Total Liabilities.
A 30% solvency ratio indicates that for every ₹1 of liabilities, the company has ₹0.30 of income. This metric reflects the company’s ability to meet its long-term obligations and remain solvent. It suggests that the company is relatively healthy in terms of its ability to cover long-term commitments with its earnings, although the adequacy of this ratio can vary by industry standards. A higher solvency ratio is generally viewed as a positive indicator of financial stability.
There are several types of solvency ratios used to assess a company’s financial health, but four main ones are commonly referenced:
Debt-to-asset ratio: Measures the portion of a company’s assets financed by debt.
Debt-to-equity ratio: Compares a company’s total liabilities to its shareholder equity.
Debt-to-capital ratio: Indicates the ratio of debt to the total capital of the company.
Interest coverage ratio: Evaluates a company’s ability to pay interest on its outstanding debt.
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