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What is a solvency ratio?

Solvency Ratio

Solvency ratio is a metric that measures a company’s ability to finance its long-term debt obligations. Solvency ratio is an important indicator of an enterprise’s financial health and is used to evaluate a company’s creditworthiness.

Some of the most important solvency ratios used are the equity ratio, the debt-to-assets ratio, the debt-to-equity ratio and the interest coverage ratio.

In this article we will learn the solvency ratio meaning and study various ways to find a solvency ratio. 

In short, a solvency ratio measures a company’s debt-paying ability. Solvency ratios and liquidity ratios are two important gauges of a company’s survivability.

However, the two indicators differ, as solvency ratios assess a company’s longer-term debt financing while liquidity ratios determine a company’s ability to pay off its short-term debt. Moreover, solvency ratios assess all the assets of a company while liquidity ratios only look at the most liquid assets, such as cash in hand, to see if the company can cover its near-term debt obligations.

These ratios vary among different industries, therefore a company’s solvency ratio should be compared with that of an industry peer. 

Solvency ratio example: Insurance sector 

Solvency ratios are particularly important when evaluating the financial health of an insurance company. As a policyholder, you want to own insurance policies of an insurer capable of settling your claims. As an investor, you have to invest in shares of a financially sound insurance firm. Solvency ratios, thus, are important metrics to measure the risks an insurer poses.

Insurance companies around the world are required to hold a certain amount of capital known as a solvency capital requirement, which is calculated to cover an insurer’s obligations to policyholders over the next 12 months.

Types of solvency ratios 

How to calculate solvency ratios? Here are the different types of solvency ratio formulas.

Equity ratio 

An equity ratio or a shareholder equity ratio shows how much shareholders of a company might receive if their company was forced to liquidate. The equity ratio is calculated by dividing the total shareholders’ equity by the total assets of the company. 

The equity ratio shows how much of a company’s assets has been funded by issuing shares versus via debt. A low-equity ratio indicates that a company has taken on debt to pay for its assets.

Equity ratio = Total shareholder equity / Total assets

Debt-to-asset ratio

Similar to an equity ratio, a debt-to-asset ratio tells you how much of a company’s assets have been funded by taking on debt. Here a company’s entire debt is considered – its accounts payable, all of its assets and its intangibles are all taken into account. A higher debt-to-asset ratio indicates a riskier investment due to higher degree of leverage.

Debt-to-asset ratio = Total debt / Total assets

Debt-to-equity ratio

A debt-to-equity ratio or DE ratio measures the ability of a company’s equity to cover outstanding debt. A high DE ratio indicates that a company is using debt to finance its growth. 

Debt-to-equity ratio = Outstanding debt / Shareholder equity

Interest-coverage ratio

An interest coverage ratio measures a company’s ability to finance its interest payments on outstanding debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense for a given period. A high interest-coverage ratio indicates less risk of interest payment default by a company.

Interest coverage ratio = Earnings before interest and taxes (EBIT) / Interest expense

It’s important to consider various ratios to estimate a company’s overall financial health. 

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