It is a well-established fact that while investing in stocks, it is important to do the basic fundamental and technical analysis. It will help the investors make better investment decisions and also compare the many investment options. The fundamental analysis of a company involves the study of its financial statements as well as many types of ratios. These ratios can tell about the financial position of the company as well as if the stock is worth investing in. Solvency ratios are some of the most important ratios that have to be analyzed by investors.
Given below are the meaning of the solvency ratios and other important details.
What is a Solvency Ratio?
A company can rarely be run simply with shareholders’ funds. There is always a debt component (usually long-term and short-term) to back its operations and growth prospects. Solvency ratios help the investors calculate the company’s ability to service its debt i.e., measuring the company’s ability to meet its financial obligations.
Evaluating the solvency ratios helps the company too in optimizing its processes and resource allocation for increasing the profitability of the company. Solvency ratios also include the measuring of the actual cash flow into the business as against the net income. This will help in the evaluation of the company’s actual cash position and its ability to meet its regular interest payments with ease.
What is the formula to calculate solvency ratios?
As mentioned above, solvency ratios are used to calculate the solvency of the company. The formula for the solvency ratio is calculated based on the net income and the total liabilities of the company. The net income has to include all the non-cash expenses like depreciation as it is the measure of the true cash position of the company. The liabilities of the company on the other hand include short-term liabilities as well as long-term liabilities.
|Solvency Ratio = (Net Income + Non-cash expenses) / Total Liabilities of the company|
Let us consider the following example to understand the calculation of the solvency ratio.
Company A has a net income of Rs. 1,00,000 after charging depreciation of Rs. 50,000. The debt position of the company includes short-term liabilities of Rs. 1,00,000 and long-term liabilities of Rs. 4,00,000. The solvency ratio of company A will be calculated below.
Solvency ratio = (100000+50000) / (100000+400000) = 0.3 or 30%
A solvency ratio of 30% is quite excellent and indicates a very healthy financial position of the company. It assures the investors and the shareholders that the company can repay their financial obligations with ease and are not cash-strapped.
What is the importance of the solvency ratio?
Solvency ratios are an important measure for companies to keep track of their debt levels as well as ensure that the company does not have any liquidity issues. The importance of the solvency ratio can be highlighted in the following points.
- Solvency ratios are one of the basic ratios to be considered to evaluate the growth potential and the financial soundness of the company.
- Solvency ratios are a good measure to understand the net cash flow in the company as well as plan for future cash flows.
- The company can keep a track of the debt-equity position of the company and ensure that they are not overly dependent on debt for its operations.
- Solvency ratios can also be used to allocate the resources of the company in an effective manner.
What are the types of solvency ratios?
The calculation of the solvency ratio is explained above. However, there are many other components or types of solvency ratios that are used by investors or companies to measure the solvency of the company. Some of such ratios are measured below.
Debt equity ratio
The debt-equity ratio is the measure of the relationship between the long-term debt and equity of the company. The long-term debt of the company includes debentures and other long-term loans of the company. The equity of the company, on the other hand, includes the total share capital (Equity share capital, preference share capital, and reserves after reducing the fictitious assets in the balance sheet). The debt ratio is calculated using the following formula,
|Debt ratio = Long term debt/Share Capital|
The ideal debt-equity ratio for every industry is different based on many factors but it cannot be more than 2:1. A low debt-equity ratio could be interpreted as the company is financially sound. A higher debt-equity ratio indicates the company is quite risky and can keep potential investors away from the company.
A debt ratio of the company is the measure of the company’s long-term debt and the capital employed. The formula for debt ratio is given below,
|Debt ratio = Long term debt / Capital Employed|
A low debt ratio will also indicate financial stability and which can attract more investors and creditors. A higher debt ratio can in turn create aversions for the investors with respect to the company’s solvency.
The equity ratio can be considered to be the other side of the debt ratio. Like the debt ratio compares the total debt with the capital employed, the equity ratio compares the owners’ funds or the shareholders’ funds and the capital employed.
|Equity ratio = Shareholders Funds/ Capital Employed|
Unlike the debt ratio, a higher equity ratio assures the investors and creditors of the financial health of the company as the majority of the capital is through equity capital.
Interest coverage ratio
The interest coverage ratio is an important part of the solvency ratios. It is the calculation of the company’s ability to cover its interest cost. A higher interest coverage ratio indicates the financial soundness of the company as it is in a better position to meet its financial obligations. The formula for the interest coverage ratio is mentioned below.
|Interest coverage ratio = Net profit before interest and tax / Interest on long term debt|
Solvency ratios are one of the key parameters that have to be considered by investors and creditors as part of the fundamental analysis. It will help the investors safeguard their investment or exit it on a timely basis before they make heavy losses to their portfolio. Solvency ratios are also one of the key ratios reviewed by the management and the auditors of the company to maintain the financial health of the company.
Solvency and liquidity ratios are often used in the same tone and are interchanged. However, the basic difference between the two is that the former focuses on the long-term viability of the company while the latter focuses on the ability to meet the short-term commitments of the company.
The basic shortcoming of the solvency ratio is that it does not focus or factor in the company’s ability to secure additional funding.
When the solvency ratio of the company is lower than 1, it is considered to be high risk. It can raise an immediate red flag regarding the financial health and viability of such a company.
An investor can calculate the solvency ratios of any company by getting the necessary data through its financial statements.
Some of the common ratios to calculate the liquidity of a business are the current ratio, quick ratio, or acid test ratio.