Solvency ratios compare different elements of an organization's financial statements. The intent of this comparison is to discern the ability of the target entity to remain solvent. Solvency ratios are commonly used by lenders and in-house credit departments to determine the ability of customers to pay back their debts. Examples of solvency ratios are:
- Current ratio. This is current assets divided by current liabilities, and indicates the ability to pay for current liabilities with the proceeds from the liquidation of current assets. The ratio can be skewed by an inordinately large amount of inventory, which can be hard to liquidate in the short term.
- Quick ratio. This is the same as the current ratio, except that inventory is excluded (which makes it a better indicator of solvency). The remaining assets in the numerator are more easily convertible into cash.
- Debt to equity ratio. This compares the amount of debt outstanding to the amount of equity built up in a business. If the ratio is too high, it indicates that the owners are relying to an excessive extent on debt to fund the business, which can be a problem if cash flow cannot support interest payments.
- Interest coverage ratio. This measures the ability of a company to pay the interest on its outstanding debt. A high interest coverage ratio indicates that a company can pay for its interest expense several times over, while a low ratio is a strong indicator that a company may default on its loan payments.
If there is a specific ratio that is considered the essential solvency ratio, it is a comparison of profits before non-cash items, divided by all liabilities. The formula is:
(Net after-tax profits + Depreciation + Amortization) ÷All liabilities
A high solvency ratio indicates a better ability to meet the obligations of the business. However, the ratio is not fully indicative of solvency, since it is based on profits, which do not necessarily equate to cash flows. A solvency analysis also does not account for the ability of a business to obtain new long-term funding, such as through the sale of shares or bonds.
It is best to review all solvency ratios on a trend line, to see if the condition of a business is worsening over time.