The solvency ratio is used to examine the ability of a business to meet its long-term obligations. The ratio is most commonly used by current and prospective lenders. The ratio compares an approximation of cash flows to liabilities, and is derived from the information stated in a company's income statement and balance sheet. The ratio will not be accurate to the extent that an organization does not recognize contingent liabilities. The solvency ratio calculation involves the following steps:
- Add all non-cash expenses back to after-tax net income. This should approximate the amount of cash flow generated by the business.
- Aggregate all short-term and long-term obligations of the business.
- Divide the adjusted net income figure by the liabilities total.
The formula for the ratio is:
(Net after-tax income + Non-cash expenses) ÷ (Short-term liabilities + Long-term liabilities)
A higher percentage indicates an increased ability to support the liabilities of a business over the long-term.
Though this measurement appears simple, its derivation hides a number of problems. Consider the following issues:
- A company may have reported an unusually high proportion of earnings not related to its core operations, and which may therefore not be repeatable during the time period required to pay off the company's liabilities. Consequently, net after-tax operating income is a better figure to use in the numerator.
- The short-term liabilities used in the denominator are more likely to fluctuate considerably in the short-term, so the measurement results could vary widely if calculated just a few months apart. This issue can be mitigated by using an average short-term liabilities figure.
- The ratio assumes that a company will pay off all of its long-term liabilities, when it may be quite likely that the business can instead roll forward the debt or convert it to equity. If so, even a low solvency ratio may not indicate eventual bankruptcy.
In short, there are so many variables that can impact the ability to pay over the long term that using any ratio to estimate solvency can be dangerous.