Solvency Ratio

How to Calculate a Solvency Ratio (Step-by-Step)

A solvency ratio assesses the long-term viability of a company – namely, if the financial performance of the company appears sustainable and if operations are likely to continue into the future.

• Liabilities: Liabilities are defined as obligations that represent cash outflows, most notably debt, which is the most frequent cause of companies becoming distressed and having to undergo bankruptcy. If debt is added to a company’s capital structure, a company’s solvency is put at increased risk, all else being equal.
• Assets: On the other hand, assets are defined as resources with economic value that can be turned into cash (e.g. accounts receivable, inventory) or generate cash (e.g. property, plant & equipment, or “PP&E”).

With that said, for a company to remain solvent, the company must have more assets than liabilities – otherwise, the burden of the liabilities will eventually prevent the company from staying afloat.

Solvency Ratio Formula

Solvency ratios compare the overall debt load of a company to its assets or equity, which effectively shows a company’s level of reliance on debt financing to fund growth and reinvest into its own operations.

1. Debt-to-Equity Ratio Formula

The debt-to-equity ratio compares a company’s total debt balance to the total shareholders’ equity account, which shows the percentage of financing contributed by creditors as compared to that of equity investors.

• Higher D/E ratios mean a company relies more heavily on debt financing as opposed to equity financing – and therefore, creditors have a more substantial claim on the company’s assets if it were to be hypothetically liquidated.
• A D/E ratio of 1.0x means that investors (equity) and creditors (debt) have an equal stake in the company (i.e. the assets on its balance sheet).
• Lower D/E ratios imply the company is more financially stable with less exposure to solvency risk.

2. Debt-to-Assets Ratio Formula

The debt-to-assets ratio compares a company’s total debt burden to the value of its total assets.

This ratio evaluates whether the company has enough assets to satisfy all its obligations, both short-term and long-term – i.e. the debt-to-assets ratio estimates how much value in assets would be remaining after all the company’s liabilities are paid off.

• Lower debt-to-assets ratios mean the company has sufficient assets to cover its debt obligations.
• A debt-to-assets ratio of 1.0x signifies the company’s assets are equal to its debt – i.e. the company must sell off all of its assets to pay off its debt liabilities.
• Higher debt-to-assets ratios are often perceived as red flags, since the company’s assets are inadequate to cover its debt obligations. This may imply that the current debt burden is too much for the company to handle.

Like the debt-to-equity ratio, a lower ratio (<1.0x) is viewed more favorably, as it indicates the company is stable in terms of its financial health.

3. Equity Ratio Formula

The third solvency ratio we’ll discuss is the equity ratio, which measures the value of a company’s equity to its assets amount.

The equity ratio shows the extent to which the company’s assets are financed with equity (e.g. owners’ capital, equity financing) rather than debt.

In other words, if all the liabilities are paid off, the equity ratio is the amount of remaining asset value left over for shareholders.

• Lower equity ratios are viewed as more favorable since it means that more of the company is financed with equity, which implies that the company’s earnings and contributions from equity investors are funding its operations – as opposed to debt lenders.
• Higher equity ratios signal that more assets were purchased with debt as the source of capital (i.e. implying the company carries a substantial debt load).