4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.

com

Career development What Is a Solvency Ratio? Definition, Types and Examples

What Is a Solvency Ratio? Definition, Types and Examples

Indeed Editorial Team
Updated January 31, 2023

Solvency is an important indicator of a company's long-term financial health. Measuring solvency ratios gives professionals insight into how efficiently
Career Guide
companies pay off debt and interest and use assets to fund operations. If you're interested in developing cost-reduction strategies and achieving
profitable outcomes, it might be helpful to learn more about solvency ratios and how to measure them.

In this article, we discuss what a solvency ratio is, what types of solvency you can evaluate, why solvency is important and how to calculate various
ratios with examples to guide you.

Key takeaways:

Solvency ratios measure a company's ability to meet its future debt obligations while remaining profitable.

There are four primary solvency ratios, including the interest coverage ratio, the debt-to-asset ratio, the equity ratio and the debt-to-equity ratio.

Creditors and investors often use solvency ratios to gauge the sustainability of a business before lending or investing.

Related: How To Calculate Operating Cash Flow

Related jobs on Indeed

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 1/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Part-time jobs

Full-time jobs

Remote jobs

Urgently hiring jobs

View more jobs on Indeed

What is a solvency ratio?

A solvency ratio is a financial metric that measures a company's ability to cover long-term liabilities and shows how efficiently it generates cash flow to
meet future debt obligations. Solvency ratios indicate the financial health of a business and help investors, managers and shareholders better evaluate
profitability. Solvency ratios incorporate several different factors and are often part of a larger analysis that determines whether businesses can
remain profitable over time.

The first factor is actual cash flow rather than net income. When measuring this, companies account for depreciation and expenses to understand
financial capacity. When measuring solvency, professionals also consider all debt obligations instead of only a company's short-term liabilities.

Related: Cash Flow vs. Net Income: 6 Fundamental Differences

Why is it important to measure solvency?

Measuring solvency can help business leaders accomplish the following tasks:

Project future cash flows: Solvency ratios are essential for understanding how business operations and financial activities affect cash flow. Using
data from ratio analysis, companies can better forecast potential cash flow over longer periods.

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 2/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Monitor long-term liabilities: Companies can also use solvency ratios to keep track of the value of long-term debts over time and how effectively
cash flow covers these liabilities. The information professionals gain from solvency calculations can help teams develop more effective methods for
monitoring debt and interest.

Establish budgets: Solvency is also important for setting budgets. Using the data from solvency calculations, you can better determine how to
allocate revenue and reduce costs.

Evaluate financial risk: Investors and shareholders often evaluate solvency to assess a company's long-term profitability and potential for growth. A
company that efficiently distributes cash flow to cover long-term liabilities indicates a lower risk of defaulting on payments, giving investors more
insight into the company's financial health.

Related: What Is a Financial Ratio?

How do solvency ratios work?

Solvency ratios consist of various metrics that all measure financial consistency in long-term debt repayment, accrued interest, tax deferments and
outstanding shares using cash flow and assets. Instead of evaluating only the short-term activities, solvency ratios consider both short- and long-
range cash flow to understand how effectively companies can cover current and future debts. When measuring solvency, you calculate several types
of ratios using specific formulas to gather financial data on long-term interest, assets, liabilities and equity and record this information alongside
liquidity values on a balance sheet.

Related: What Is Ratio Analysis? Definition and Uses (With Examples)

Types of solvency ratios

There are several key types of solvency ratios companies use to evaluate overall profitability and financial health:

Interest coverage ratio

The interest coverage ratio evaluates the rate at which a company can meet its current interest obligations with the cash flow it has available. This
metric is important as it shows the margin of safety you have for paying interest you accrue on debt for the period. An interest coverage ratio higher
than 1.5 is a positive indicator a company can cover meeting its interest obligations. To calculate the interest coverage ratio, divide the EBIT value by the
total interest expense. A company's EBIT represents its earnings before deducting interest and taxes.

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 3/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Debt-to-asset ratio

The debt-to-asset ratio compares total debts to total assets. This metric is important for understanding how well companies use assets over debts to
fund business operations and provides insight into overall financial leverage. Debt-to-asset ratios also give insight into a company's ability to allocate
its available assets efficiently enough to meet its debt obligations. Typically, a debt-to-asset ratio greater than one indicates more funding through
debt, whereas a ratio less than one shows companies use more assets to fund operations. To calculate the debt-to-asset ratio, divide the total debt by
the total asset value.

Read more: What Is the Debt to Asset Ratio? Plus How To Calculate and Interpret It

Equity ratio

The equity ratio compares equity to assets and measures how much equity a company uses to fund its operations as opposed to debts. A higher equity
ratio indicates companies use more equity over debt, while lower ratios indicate a company uses more debt than equity to support business outcomes.
To calculate the equity ratio, divide the total shareholder equity by the total assets.

Debt-to-equity ratio

The debt-to-equity ratio measures how much debt a company uses to fund its operations in comparison to equity. When a company uses its debt to
pay for ongoing business activities, it's necessary to monitor equity to ensure this value is substantial enough to cover debts should the company need
to liquidate. So the higher the ratio, the higher the debt value is to fund a company's growth. To calculate the debt-to-equity ratio, divide all
outstanding debts by the total value of equity.

Read more: Debt-to-Equity Ratio: Definition and Calculation Formula

How to calculate solvency ratios

You can use the following approaches to calculate the different solvency ratios:

1. Determine the metric you're measuring

Determine which solvency ratio you want to measure by evaluating which business processes need assessment. For instance, a business that wants to
analyze and compare its total debts to total assets would look at the solvency ratio for debts to assets. You can also evaluate which aspects of the cash

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 4/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

flow you want to measure, such as incoming and outgoing cash flow. Incoming cash flow can consist of assets and equity, while outgoing cash flow
defers to paying off liabilities and expenses.

Related: What Are Liquidity Ratios? Definition and Example

2. Gather necessary financial data

Collect the financial data necessary for the solvency ratio you want to calculate. For example, a company that wants to assess its ability to cover more
of its operations with equity rather than debt would gather information about total shareholder equity, current and long-term debts. After gathering
the necessary financial data, you can apply it to specific formulas to get the solvency ratio you're evaluating.

3. Apply the appropriate formula

There are several key formulas to use when evaluating the different solvency metrics. Here are the formulas you can use for each one:

Interest coverage ratio = EBIT ÷ Current interest

Debt-to-asset ratio = Total debt ÷ Total assets

Equity ratio = Total shareholder equity ÷ Total assets

Debt-to-equity ratio = Total debt ÷ Total equity

After calculating the appropriate ratio formula, you can evaluate the results and collaborate with team members to develop strategies for reducing
costs and increasing cash flow to support ongoing business operations.

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 5/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Show Transcript

Video: How to Calculate Ratios

Don’t be overwhelmed with calculating ratios! This video has all you need to know on methods for determining ratios with
examples. Watch and learn!

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 6/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Upgrade your resume

Showcase your skills with help from a resume expert

Solvency ratio examples

Consider the following examples for additional insight into calculating each solvency ratio:

Interest coverage ratio example

Wyland Technology Corporation measures its solvency to evaluate its long-term capability of taking on more debt to acquire a new facility. Before applying
for funding, the company assesses whether its available cash flow is enough to cover current interest obligations. If the company has excess cash flow after
deducting its current interest expense, financial analysts can determine if the company is able to cover the new debt. Analysts calculate the company's EBIT
value at $5,780,000 and its current interest obligations at $2,200,000. Calculating the interest ratio gives the company:

Interest ratio = EBIT ÷ Current interest

$5,780,000 ÷ $2,200,000 = 2.63

Related: Interest Expenses: Definition, How To Calculate and Example

Debt-to-asset ratio example

The executive managers at Highlands Automotive are evaluating the company's solvency using the debt-to-asset calculation to better understand how much
debt the company has for funding business operations. The accountant first calculates all outstanding debts the company covers, including long-term
liabilities and short-term debt obligations. Then, the accountant calculates all current and long-term assets, including inventory, revenue, investment
returns and available cash flow. With a total debt value of $445,000 and a total asset value of $425,000, the accountant finds the debt-to-asset ratio by
dividing:

Debt-to-asset = Total debt ÷ Total assets

$445,000 ÷ $425,000 = 1.04

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 7/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Related: Cash Ratio: What It Is and How To Use It (With Example)

Equity ratio example

Theta Bionics has equity in shareholder stock, property assets and investment returns. Although the company is expanding, finance professionals want to
evaluate how much of the expansion comes from equity and assets compared to taking on more debt. Using the equity ratio, financial analysts calculate the
company's shareholder equity at $7,890,000 and the total assets at $6,350,000. Dividing these two metrics gives the analysts:

Equity ratio = Total shareholder equity ÷ Total assets

$7,890,000 ÷ $6,350,000 = 1.24

Related: How To Conduct a Financial Statement Analysis in 3 Steps

Debt-to-equity ratio example

Trivega Industries wants to measure how much debt it uses to cover the costs of its production operations. The company has to cover a certain amount in
liabilities for both short- and long-term periods. Understanding how much debt the company uses can help investors and financial planners assess the
long-term profitability and sustainability of the company.

While the company uses some of its equity to fund the costs of operation, investors want to know the exact rate of debt funding in comparison to equity
funding. Analysts and investors evaluate the total amount of debt the company currently owes and divide this value by the total amount of equity the
company accrues, including shareholder equity. With a total debt value of $4,500,000 and a total equity value of $7,800,000, investors find the debt-to-
equity ratio:

Debt-to-equity = Total debt ÷ Total equity

$4,500,000 ÷ $7,800,000 = 0.58

Share:

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 8/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Is this article helpful?

Indeed Career Services

Resume Services
Get your resume reviewed or rewritten

Upgrade your resume

Interview Practice
Practice interviewing with an expert career coach

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 9/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Book a session

Indeed Resume
Get noticed by employers

Upload a resume file

Salary Calculator
See your personalized pay range

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 10/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

Get your estimate

Resume Samples
Kick start your search with templates

Browse resume samples

Company Reviews
Access millions of company reviews

Find companies

Explore more articles

50 Ice Breaker Questions for Work Situations

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 11/12

4/2/24, 2:35 PM What Is a Solvency Ratio? Definition, Types and Examples | Indeed.com

9 Tips To Write an Interesting Hook

Self-Performance Review Goals: Benefits and Examples

Letter and Email Salutations Examples (Plus Tips)

How To Write an Employment Reference Letter (With Template)

7 Finance Certifications You Can Get Without a Degree

80 Strategic Questions to Ask Your Mentor (With Tips)

12 Time-Management Problems (and How To Fix Them)

How To Write a Return-To-Work Letter in 5 Steps (With Examples)

Sampling Distribution: Definition, Factors and Types

20 Examples of Marketing Metrics and KPIs (With Definitions)

13 Types of IT Services: What They Are and How They Help

Hiring Lab Career Advice Browse Jobs Browse Companies Salaries Indeed Events Work at Indeed Countries About Help Center ESG at Indeed

© 2024 Indeed Your Privacy Choices Accessibility at Indeed Privacy Center and Ad Choices Terms

https://www.indeed.com/career-advice/career-development/solvency-ratio#:~:text=There are four primary solvency,business before lending or investing. 12/12