What is the solvency ratio?
A solvency ratio measures how well a company can pay its long-term financial obligations. It compares the company’s earnings with its liabilities to assess its financial stability. A high or strong solvency ratio indicates that the company is in good financial shape and can meet its obligations easily. A low ratio, however, suggests that the company may face financial difficulties in the future. A solvency ratio is very important for lenders, potential investors, suppliers, and anyone interested in doing business with a particular company.
Explanation of Solvency Ratio
The solvency ratio is one of the measurements to know a business's financial health that how well it can pay off its long-term debts and obligations. A solvency ratio looks at the actual cash flow of a company, not just its net income, by adding back any non-cash expenses like depreciation that reduce its income but not its cash.
A solvency ratio weighs up this cash flow to all company liabilities. This gives a better picture of the company’s long-term financial health and its ability to pay back its long-term debt and interest.
Solvency ratio is also a term insurance companies use to measure how much capital they have compared to the premium they collect. And how much risk they might face of being unable to cover the claims they receive.
Formula for calculating Solvency Ratio
Solvency Ratio = (Net income + Depreciation) / All obligations (Long-term + Short-term liabilities