Solvency Ratio - Definition, What is Solvency Ratio, Advantages of Solvency Ratio, and Latest News - ClearTax (2024)

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Solvency Ratio - Definition, What is Solvency Ratio, Advantages of Solvency Ratio, and Latest News - ClearTax? ›

A solvency ratio is a vital metric used to see a business's ability to fulfil long-term debt requirements and is used by prospective business lenders. It shows whether a company's cash flow is good enough to meet its long-term liabilities. It is, therefore, considered to a measure of its financial health.

Advantages of Solvency Ratio:

Solvency ratios measure the capacity of the company to earn revenues to pay off debt, which analysts and investors widely use to analyse the company's performance. These investors compare the historical solvency ratios with the present to get an idea of how the company is performing.

A solvency ratio measures how well a company's cash flow can cover its long-term debt. Solvency ratios are a key metric for assessing the financial health of a company and can be used to determine the likelihood that a company will default on its debt.

Practical Example. Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%.

Short-term solvency ratios. Ratios used to judge the adequacy of liquid assets for meeting short-term obligations as they come due, including (1) the current ratio, (2) the acid test ratio, (3) the inventory turnover ratio, and (4) the accounts receivable turnover ratio.

It can give valuable insight into what's happening with a company's management team. It also helps assess their ability to turn an investment into income. The profitability index also has its disadvantages. It isn't always possible to measure the value of a business or whether or not an investment was successful.

Thus, solvency ratio indicates whether the company's cash flow is adequate to pay its total liabilities. Amount (in Rs.) Then, if we use these numbers into the formula given above, we get: Solvency ratio = (15,000 + 3,000) / (32,000 + 60,000) = 19.6%.

The solvency ratio is a debt evaluation metric that can be applied to any type of company to assess how well it can cover both its short-term and long-term outstanding financial obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Solvency ratios also known as leverage ratios determine an entity's ability to service its debt. So these ratios calculate if the company can meet its long-term debt.

Why is solvency important? ›

Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency can be an important measure of financial health, since it's one way of demonstrating a company's ability to manage its operations into the foreseeable future.

The solvency of a company can help determine if it is capable of growth. Also, solvency can help the company's management meet their obligations and can demonstrate its financial health when raising additional equity. Any business looking to expand in the long term should aim to remain solvent.

As of the end of March 2022, Sahara India Life Insurance Company Ltd had the highest solvency ratio of 6.75 percent. Whereas, Life Insurance Corporation of India had a solvency ratio of 1.85 percent.

It is calculated by dividing company's EBIT (Earnings before interest and taxes) with the interest payment due on debts for the accounting period. Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.

Gross profit margin, also known as gross margin, is one of the most widely used profitability ratios. Gross profit is the difference between sales revenue and the costs related to the products sold, the aforementioned COGS.

In general, a ratio around 0.3 to 0.6 is where many investors will feel comfortable, though a company's specific situation may yield different results.

Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency can be an important measure of financial health, since it's one way of demonstrating a company's ability to manage its operations into the foreseeable future.

Liquidity ratios are a measure of the ability of a company to pay off its short-term liabilities. Liquidity ratios determine how quickly a company can convert the assets and use them for meeting the dues that arise. The higher the ratio, the easier is the ability to clear the debts and avoid defaulting on payments.

Advantages of Ratio Analysis are as follows:

Helps in forecasting and planning by performing trend analysis. Helps in estimating budget for the firm by analysing previous trends. It helps in determining how efficiently a firm or an organisation is operating.

The solvency of a company can help determine if it is capable of growth. Also, solvency can help the company's management meet their obligations and can demonstrate its financial health when raising additional equity. Any business looking to expand in the long term should aim to remain solvent.