What Is a Solvency Ratio?

A solvency ratio is a measurement of a firm's financial health. It indicates whether a company’s cash flow is sufficient to meet its 澳洲幸运5官方开奖结果体彩网:long-term liabilities. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.

How Solvency Ratios Work

A solvency ratio is one of many metrics used to determine whether a company can stay solvent in the long term. A solvency ratio is a comprehensive measure of solvency, as it measures a firm's actual cash flow, rather than net income, by adding back 澳洲幸运5官方开奖结果体彩网:depreciation and other non-cash expenses to as🍌sess a company’s capacity to stay afloat.

It measures this cash flow capacity versus all liabilities rather than only 澳洲幸运5官方开奖结果体彩网:short-term debt. This way, a solvency ratio assesses a company's long-term health by evaluating it🍰s repayment ꧂ability for its long-term debt and the interest on that debt.

So🤡lvency ratios vary from industry to industry. A company’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation.

A solvency rati🐎o terminology is also used when evaluating insurance companies, comparing the size of their capital relative to the premiums written, and measurin🌺g the risk an insurer faces on claims it cannot cover.

Types of Solvency Ratios

Interest coverage ratio

The interest coverage ratio is calculated as follows:

$\text{Interest Coverage Ratio}=\frac{\text{EBIT}}{\text{Interest Expenses}}$Interest Coverage Ratio=Interest ExpensesEBIT​

where:

• EBIT = Earnings before interest and taxes

The interest coverage ratio me൩asures how many times a company can cover its current interest payments with its available earnings. In other words, it measures the margin of safety a company has for paying i🐟nterest on its debt during a given period.

The higher the ratio, the better. If the ratio falls to𒀰 1.5 or below, it may indicate that a company will have diff🌃iculty meeting the interest on its debts.

Debt-to-assets ratio

The 澳洲幸运5官方开奖结果体彩网:debt-to-assets ratio is calculated as follows:

$\text{Debt-to-Assets Ratio}=\frac{\text{Debt}}{\text{Assets}}$Debt-to-Assets Ratio=AssetsDebt​

The debt-to-assets ratio measures a company's total debt to its total asset🥃s. It measures a company's leverage and indicates how much of the company is funded by debt versus assets, and therefore, its ability to pay off its debt with its available assets. A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have difficulty meeting its obligations.

Equity ratio

The 澳洲幸运5官方开奖结果体彩网:shareholder equity ratio is calculated as follows:

$\begin{aligned}&\text{SER}=\frac{\text{TSE}}{\text{Total assets}}\\\textbf{where:}\\&\text{SER}\!=\!\text{Shareholder equity ratio}\\&\text{TSE}\!=\!\text{Total shareholder equity}\end{aligned}$where:​SER=Total assetsTSE​SER=Shareholder equity ratioTSE=Total shareholder equity​

The equity ratio, or equity-to-assets, shows how much of a c🥃ompany is funded by equity ✅as opposed to debt. The higher the number, the healthier a company is. The lower the number, the more debt a company has on its books relative to equity.

Debt-to-equity (D/E) ratio

The 澳洲幸运5官方开奖结果体彩网:debt-to-equity (D/E) ratio is calculated as follows:

$\text{Debt to Equity Ratio}=\frac{\text{Debt Outstanding}}{\text{Equity}}$Debt to Equity Ratio=EquityDebt Outstanding​

The D/E ratio is similar to the debt-to-assets ratio in that it indicates how a company is funded, in this case, by debt. The higher the ratio, the more debt a company has on its books, meaning the likelihood of default is higher. The ratio looks at how much of the debt can be covered by equity if the company needs to liquidate.

Solvency Ratios vs. Liquidity Ratios

Solvency ratios and liquidity ratios are similar but have some 澳洲幸运5官方开奖结果体彩网:important differences. Both of these categories of 澳洲幸运5官方开奖结果体彩网:financial ratios will indicate the health of a company. The main difference is that solvency ratios offer a longer-term outlook on a compa⛎ny, whereas liꦿquidity ratios focus on the shorter term.

Solvency ratios look at all assets of a company, including long-term debts such as bonds with maturities longer than a year. Liquidity ratios, on the other hand, look at just the most 澳洲幸运5官方开奖结果体彩网:liquid assets, such as cash and 澳洲幸运5官方开奖结果体彩网:marketable securities, an♔d how those can be used to cover upcoming obligations in the near term.

If an investor wants to know whether a company will be able to pay its bills next year, they are often most interested in looking at the liquidity of the company. If a company is illiquid, it won't be able to pay its short-term bills as they come due. On the other hand, investors more interested in a long-term health assessment of a company would want to analyze solvency ratios.

Limitations of Solvency Ratios

A c🌠ompany may have a low debt amount, but if its cash m🥃anagement practices are poor and accounts payable are surging, as a result its solvency position may not be as solid as would be indicated by measures that include only debt.

It's important to look at a variety of ratios to comprehend the true 澳洲幸运5官方开奖结果体彩网:financial health of a company, as well as understand the reason that a ratio is what it is. Furthermore, a number itself won't give much of an indication. A company needs to be compared to its peers, particularly the strong comꦬpanies in its industry, to determine if the ratio is an acceptable one or not.

For example, an airline company will have more debt than a technology firm just by the nature of its business. An airline company has to buy planes, pay for hangar space, and buy jet fuel; costs that are significantly🎀 more than a technology company will ever have to face.

Examples of Solvency Ratios

Below is a screenshot of Amazon's financial position at the end of 2024. At the end of Dec. 31, 2024, Amazon had $624.9 billion of total company assets:

Although total debt is not explicitly shown on the financial statement, it can easily be calculated as the difference between total assets and total stockholders' equity (both of which are shown). Using subtraction, Amazon's debt was $338.9 billion at the end of 2024 and $326.0 billion at the end of 2023.

One can get a sense of Amazon's solvency by comparing last year's debt-to-equity ratio to this year's ratio. The ratios for each year are:

• 2023 D/E Ratio: $326 billion / $201.9 billion = 1.61
• 2024 D/E Ratio: $338.9 billion / $286.0 billion = 1.18

From these two calculations, one can assess that Amazon's long-term solvency increased, and the company's financial position became less risky over the course of the year. This is because the company now has proportionally less debt on its books compared to equity.

In another example, Amazon's debt-to-assets ratio decreased.

• 2023 D/A Ratio: $326 billion / $527.9 billion = 0.62
• 2024 D/A Ratio: $338.9 billion / $625.0 billion = 0.54

This indicates that debt now makes up a smaller portion of the company's total assets. While debt increased slightly, total assets grew at a faster rate, leading to an improved ratio. This aligns with the earlier observation that Amazon's financial leverage decreased, as seen in the decline of its debt-to-equity ratio.

This means that in 2023, Amazon had 62 cents of debt for every $1 of assets, or in other words, 62% of its assets were financed through debt. In 2024, while Amazon's total debt increased slightly, its total assets grew at a faster pace, reducing the debt-to-asset ratio to 0.54. That means only 54% of the company's assets are now financed by debt.

Slight changes like this may💖 not be significant on their own, but consistent long-term trends or major year-over-year shifts can reveal how effecti💮vely a company is managing its capital structure and financial risk.

The Bottom Line

Solvency ratios are financial measurements that usually look at a company's total assets, total debt, or total equity to better understand the company's financing structure.

This financial structure plays a critical part in knowing whether the company will bไe able to pay its long-term debts as they come due and have enough money in the long run. The most common solvency ratios are the debt-to-equity ratio, the debt-to-assets ratio, and the interest coverage ratio.