Companies prefer raising funds through debt capital as it is cost-effective. In this way, they can save themselves from paying high-interest rates if they raise through financial institutions. Although, if companies raise more than a certain limit, interest payments can harm the balance sheet and profitability.
Ratios, specifically the solvency ratio, compare the debt element of the company with others. Stakeholders can consider assessing the Solvency Ratio. This article explains how to calculate the solvency ratio, its example, limitations, and other solvency ratios.
How to Calculate the Solvency Ratio?
The solvency ratio is an indicator of a company’s financial soundness. It suggests whether the company is capable enough to pay its long-term financial obligations. The solvency of the company is measured by comparing a firm’s net earnings with its liabilities. A higher solvency ratio means the company has enough earnings to meet its long as well as short-term liabilities. The poor solvency ratio reflects that the company is struggling to meet its future obligations.
The ideal standard ratio differs from industry to industry. Though, a solvency ratio of over 20% is considered higher in general. A higher solvency ratio is a sign that the company records higher profit per rupee of liability. The solvency ratio of the firm can be improved if it increases the net earnings or decreases its financial obligations.
Various stakeholders associated with the company use this ratio to assess the financial health of the company. These stakeholders include suppliers, suppliers, banks, lenders, shareholders, etc.
To understand how to calculate the solvency ratio, you need two key elements. One is net earnings before depreciation and another is total liabilities of the firm. Net earning is then the income of the firm after deducting the cost of goods sold, general expenses, depreciation and/or amortization, interest, and taxes. Net earnings before depreciation can be computed by adding depreciation to net income.
Total liabilities of the firm include both short-term as well as long-term liabilities. Short-term liabilities include short-term debt, accounts payable, accrued expenses, expenses payable, etc. Long-term liabilities constitute long-term bank loans, debentures, bonds, and all other non-current liabilities.
All the required information to calculate the solvency ratio can be availed from the financial statements of the company.
The following formula is used to calculate the solvency ratio.
Solvency Ratio = (Net income + Depreciation) / Total Liabilities
Example:
Piyush is considering two companies, namely ABC Limited and XYZ Limited, to choose from for investment. He found both the companies well-performing considering profitability and liquidity ratios and, decided to compare the solvency of both the companies.
He availed following information from ABC Ltd‘s financial statements. For the year ending 31st March 2021, it recorded a net profit after tax of Rs. 1,50,000. The company has assets of Rs. 5,00,000. The company considers a straight-line method for depreciation at a 10% rate. Additionally, the company has long-term debt of Rs. 7,50,000 and current liabilities of Rs. 2,50,000. You can calculate the solvency ratio of ABC ltd. using the following method.
Depreciation = 50,000 (10% of 5,00,000)
Solvency Ratio = (Net income + Depreciation) / (Short-term debt + Long term debt)
= (1,50,000 + 50,000) / (2,50,000 + 7,50,000)
= 0.2 or 20%.
For XYZ Ltd., he availed the following information.
For the year ending 31st March 2021, it recorded a net profit after tax of Rs. 2,75,000. The company has assets of Rs. 6,00,000. The company considers the straight-line method for depreciation at a 10% rate. Additionally, the company has long-term debt of Rs. 8,80,000 and current liabilities of Rs. 1,50, 000.
Calculation of solvency ratio of XYZ ltd.
Depreciation = 60,000 (10% of 6,00,000)
Solvency Ratio = (Net income + Depreciation) / (Short-term debt + Long term debt)
= (2,75,000 + 60,000) / (1,50,000 + 8,80,000)
= 0.325 or 32.52%.
According to the solvency ratio, Piyush will prefer XYZ Ltd for investment as compared to ABC Ltd. The reason is XYZ Ltd has a stronger solvency ratio i.e. it has a net income of Rs. 0.33 for every Rupee of liability. XYZ Ltd is less likely to default on obligations as compared to ABC Ltd.
Limitation of the Solvency Ratio
Though the solvency ratio is one of the important ratios when assessing financial strength, considering it in isolation brings accompanies some limitations:
- A strong solvency ratio does not guarantee a company’s financial strength, it is just one measure.
- A company can be using its large debt efficiently. Though, stakeholders can misjudge the company by looking at its lower solvency ratio.
- Some of the industries by nature require higher debt and less liquidity. For example, telecom businesses require higher debt and will have a lower solvency ratio as compared to FMCG businesses. Comparing the solvency ratio of those businesses can misguide the investors.
- The solvency ratio shows whether the ratio is higher or lower, not the reason why it is so.
Other Solvency Ratios
Other than this solvency ratio, there exist other ratios to measure a company’s ability to meet future obligations which are listed as follows:
- Debt-to-Asset ratio: To calculate the debt-to-asset ratio, the total debt of the company is divided by total assets. A higher ratio suggests higher risk and vice versa. Investors prefer the ratio of less than 1, as it implies that the company has more assets than its financial obligations.
- Debt-to-Equity ratio: This ratio reflects the company’s capital structure. It is calculated by dividing a company’s total debt by its equity capital. D/E ratio shows the amount of debt per rupee of equity.
- Debt-to-Capital ratio: This ratio helps to assess the portion of capital the company comes from debt. It is calculated by dividing the company’s total debt by the company’s total capital i.e. equity and debt capital combined.
- Interest coverage ratio: This ratio indicates the company’s ability to pay interest rates to its creditors and lenders. The interest coverage ratio is calculated by dividing the company’s earnings before interest and taxes by interest payable. A higher ratio suggests stronger solvency and vice versa.
Final Words
The solvency ratio is the measure that aids in determining the long-term financial status of the firm. Stakeholders can use this ratio to make sure that they are not invested in a company that is likely to default on financial obligations. If used along with other ratios, it proves to be an efficient measure of the company’s financial health. One can arrive at better results when comparing the solvency ratio of two or more firms.
