Solvency refers to a company’s ability to satisfy its financial liabilities with existing resources.
A company is considered solvent when its assets and cash flows are sufficient to service its liabilities. A company is considered insolvent when its assets and cash flows are insufficient to service its liabilities.
Solvency is not the same as liquidity. Liquidity refers to a company’s ability to convert existing assets to cash. A company is solvent but illiquid when its capital is in assets such as property, plant, and equipment, which cannot be easily converted to cash to satisfy current liabilities.
There are several ratios that can help business operators and analysts determine a company’s solvency. These ratios are classified as leverage ratios and coverage ratios.
Common leverage ratios include the debt-to-equity ratio, debt-to assets ratio, and debt-to-capital ratio. These ratios are calculated as follows:
Debt-to-equity = Total debt / Shareholder’s equity
Debt-to-assets = Total debt / Total assets
Debt-to-capital = Total debt / (Total debt / Shareholder’s equity)
These ratios indicate the amount of debt for every $1 of equity capital, total assets, and total capital, respectively. The lower the ratio, the greater degree of solvency.
Common coverage ratios include the interest coverage ratio and the total debt service coverage ratio. These ratios are calculated as follows:
Interest coverage = Operating profit / Interest expense
Total debt service coverage = Operating profit / (Interest expense + Principal)
These ratios indicate the amount of operating profit available for every $1 in interest expense and total debt service, respectively. With coverage ratios, the higher the ratio the greater the degree of solvency.
