The solvency ratio is used to measure a company’s ability to meet its long-term debt obligations. A high solvency ratio is usually an indicator of a healthy company with a low probability of defaulting on its debts. The solvency ratio takes into account a company’s post-tax income, excluding any non-cash depreciation expenses, in relation to its total debt obligations.
How is it calculated?
\(\mathrm{Solvency\: ratio} =\frac{\mathrm{Net \:profit \:after \:tax\: + \:Depreciation}}{\mathrm {Long-term\: liabilities\: + \:Short-term \:liabilities}}\times{100\%}\)
Example 1
|
Tech company ABC |
Tech company DEF |
| Net profit after tax |
$14,569m |
$5,704m |
| Depreciation |
$2,562m |
$703m |
| Long-term liabilities |
$11,296m |
$6,737m |
| Short-term liabilities |
$27,034m |
$19,282m |
\(\mathrm{Tech\: company\: ABC}: \frac{14,569\:+ 2,562}{11,296\:+\:27,034}\:\times 100\% =44.7\%\)
\(\mathrm{Tech\: company\: DEF}:\frac{5,704\: + \:703}{6,737\: + \:19,282}\:\times 100\% = 24.6\%\)
Example 2
|
Airline UVW |
Airline XYZ |
| Net profit after tax |
£358m |
€169.2m |
| Depreciation |
£694m |
€256m |
| Long-term liabilities |
£4,500m |
€2,618m |
| Short-term liabilities |
£4,142m |
€1,378m |
\(\mathrm{Airline\: company \:UVW}:\frac{358\: + \:694}{4,500\: + \:4,142}\:\times100\%=12.2\%\)
\(\mathrm{Airline\: company \:XYZ}: \frac{169.2\: + \:256}{2,618\: + \:1,378}\:\times{100\%}={\mathrm{10.6\%}}\)
The above examples illustrate the importance of limiting comparison of solvency ratios to single industries. However, while ratios vary from industry to industry they do provide a quick way of measuring approximately how much cash is being generated to service the company’s debt.
Companies ABC and DEF are both technology companies and therefore their solvency ratios are suitably comparable. Company DEF is more likely to default on its debts than Company ABC, but its relatively good solvency ratio indicates that it is still a fairly healthy company.
Airlines, however, operate with much higher debt than technology companies, and therefore tend to display low, or even negative, solvency ratios.
Points to consider
As with all financial debt and profitability ratios, solvency ratios should not be used in isolation, but in conjunction with other metrics. As mentioned above, it is also important to compare solvency ratios against the benchmark for the relevant industry. Treasurers need to be aware of all the factors which may affect a company’s solvency ratio and remember that an airline with a negative ratio, for example, may prove to be a more prudent investment than a technology company with a ratio of 10%.
Note that the solvency ratio used when analysing insurance companies is a totally different measure, which attempts to assess the adequacy of the insurance company’s reserves.
