What Are the Advantages and Disadvantages of Solvency Ratio?
Before investing in a company an investor needs to consider several factors to get a detailed idea about the considered investment. This helps them make an informed decision and prevents investing in a company that is in bad financial shape.
Solvency ratio is an important factor that an investor needs to know about while conducting a comparative analysis. Keep reading to know everything about the solvency ratio including its pros and cons for investors.
What Is Solvency Ratio?
The solvency ratio, also known as the leverage ratio, evaluates a company’s financial strength. It analyses if the company can repay the debts in the long run and fulfil its obligations. Potential investors use this ratio to determine whether a company is worth their financial investments in the long run.
With the help of the solvency ratio, you can compare the debt levels of a company with its earnings, fixed assets, and equity before investing. This allows you to analyse if the company can bear the debt burden in the long run.
From the perspective of a company, the solvency ratio offers an overview of its financial condition. If the solvency ratio is very low, it indicates that given its current income, a company cannot repay its loans in the future. This is not only an indicator of bankruptcy, but it also predicts that lenders might not provide more funds.
Investors also need to remember that the solvency ratio varies across industries. Therefore, while analysing companies, consider comparing firms within the same industry.
What Are the Advantages of Solvency Ratio?
The solvency ratio has the following advantages:
- It helps investors to make an informed decision before investing funds in a company. By calculating this ratio, you can avoid the risks of facing loss by investing in firms that are financially stressed.
- As an investor, you can use this ratio to periodically analyze a company’s financial health. This will allow you to determine a company’s ability to pay off debts in the long run.
- Helps in the comparison between two or more firms at the same time.
What Are the Disadvantages of Solvency Ratio?
Here are the disadvantages of the solvency ratio:
- Solvency ratio does not have a huge role to play to attract huge funding for a company. As a result, it can’t be used in a stand-alone manner. Therefore, consider analysing other ratios and insights to make an informed choice.
- There are different types of solvency ratios and each has different formulas. The procedure to calculate the solvency ratio might vary between companies. Also, the presence of different procedures to calculate this ratio can bring in different results. This can complicate your assessment of companies.
- Solvency ratio provides an incomplete picture of the company and can mislead you. This ratio only considers a company’s debt. However, it is possible that a company can cover its debts despite being highly leveraged. Such scenarios will not be reflected by the solvency ratio.
What Is the Formula to Calculate Solvency Ratio?
To calculate the solvency ratio of a company you require two important parameters. They are the net income and total liabilities of a company. As net income is the actual earnings of a company, you do not need to deduct the non-cash expenses from here. Also, total liabilities must comprise both long and short-term debts.
Although there are different procedures to calculate the solvency ratio based on its type, here is the basic formula:
Solvency Ratio= (Net Income + Depreciation)/ (short term + long term liabilities)
To understand this calculation elaborately, let’s consider an example.
The net income of Company WXY is ₹1,00,000 after depreciation of ₹50,000. This company also records a debt comprising long-term liability of ₹4,00,000 and short-term liability of ₹ 1,00,000. What shall the solvency ratio of Company WXY be?
To know the solvency ratio, let’s use the above formula and place the data accordingly.
Solvency ratio = (1,00,000+50,000)/ (1,00,000 + 4,00,000)
= 30% or 0.3
A solvency ratio of 30% indicates the excellent financial health of a company. This implies that Company WXY can repay its debts easily and will not fall short of cash in the long run.
Solvency ratio is a very important ratio in the fundamental analysis of a company. As stated earlier, the solvency ratio varies between industries. Therefore, while conducting a comparative analysis, consider assessing the solvency ratio of companies belonging to the same industry. Also, include other ratios like liquidity ratios and profitability ratios to gain detailed knowledge about the companies.
Frequently Asked Questions
What are the types of solvency ratios?
Debt-to-Equity Ratio, Interest Coverage Ratio, and Debt-to-Capital Ratio are the three main solvency ratios. By calculating these ratios you can make a comprehensive study of a company’s financial health.
What is an ideal or standard solvency ratio?
The solvency ratio varies between industries. However, according to the general notion, a company whose solvency ratio is higher than 20% has good financial health and can pay off its debts in the long run. However, companies whose solvency ratio is below 20% can be considered financially stressed.
What is the liquidity ratio?
What is the liquidity ratio?
The ratio which analyses a company’s financial health based on its ability to repay its short-term debts is called the liquidity ratio. With the liquidity ratio, you can analyse how quickly a company can convert its assets to pay off its debts.
What is the formula to calculate the interest coverage ratio?
The formula to calculate the interest coverage ratio is as follows:
Interest coverage ratio= Earnings Before Interest and Tax (EBIT)/ Interest expense.