A Definitive Guide to the Solvency Ratio (Examples and Tips)

By Indeed Editorial Team

Published 27 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Calculating the long-term outcomes of various organisations can help you learn about financial analysis, develop your business skills and plan for the consequences of certain financial decisions. One way you can track the long-term financial positions of organisations is by using solvency ratios. Knowing what solvency ratios are and how to use them can help you understand business decisions and develop your financial industry knowledge. In this article, we discuss what solvency ratios are, detail five ratios you can use, examine why they're beneficial for businesses and investors and provide tips you can use.

Related: What Is the Role of the Finance Department in Business?

What is a solvency ratio?

A solvency ratio is a calculation you can make to determine the financial position of an organisation from a long-term solvency perspective. Solvency is an organisation's ability to pay off its debts. It's also a comparison between the number of assets an organisation owns and its liabilities. There are five ratios you can use to determine the financial position of an organisation. Each one helps you find a unique value and perform further calculations.

Types of solvency ratios

Below are descriptions of the five types of solvency ratios available:

Long-term debt-to-equity ratio

The long-term debt-to-equity ratio can help you find the amount of long-term debt an organisation has taken compared to the amount of equity it owns. This calculation shows to what extent an organisation is using these debts to fund operations. If an organisation's long-term debts are higher than its total equity, it's primarily using them to fund its operations. If its total equity is higher than its long-term debts, it mainly supports itself through its own assets. Of the two options, higher total equity is better for businesses and investors because it means the organisation is self-sustaining.

The formula for long-term debt-to-equity is:

Long-term debt-to-equity ratio = long-term debt / total equity

Where:

  • Long-term debt is the combined monetary value of the organisation's loans and other liabilities that can affect its income for similar lengths of time.

  • Total equity is the combined monetary value of the organisation's accumulated earnings and money received from investors, minus the monetary value of its total liabilities.

Related: What Does an Equity Trader Do? (With Job Duties and FAQs)

Total debt-to-equity ratio

You can use the total debt-to-equity ratio to determine the total amount of debts an organisation has compared to its total equity. This calculation differs from the long-term debt-to-equity ratio because it factors in all the debts an organisation has. Besides long-term debts, an organisation may also have short-term debts that are usually paid within 12-months. These debts can include accounts payable expenses, small and short-term loans, lease payments, taxes, salaries and stock dividends. Some organisations may also call short-term debts their current liabilities.

The formula for total debt-to-equity is:

Total debt-to-equity ratio = total debt / total equity

Where:

  • Total debt is the monetary value of all liabilities an organisation owes to third-party sources, internal employees and shareholders. This can also include payments to other companies for real estate or products like cups, lids and straws.

  • Total equity is the combined monetary value of the organisation's accumulated earnings and money received from investors, minus the monetary value of its total liabilities. This value also represents anything invested into an organisation by its owner.

Debt ratio

The debt ratio is a way to find the proportion of total assets an organisation owns that's still financed by debt. It can help you determine the total leverage a business has and the risk level of its investments. The lower the ratio is, the less risky the organisation is to invest because it has a smaller debt obligation. The higher the ratio, the riskier it's for you to invest as the organisation has a higher debt obligation to other organisations, meaning it may not own its assets yet.

The formula for the debt ratio is:

Debt ratio = total debt / total assets

Where:

  • Total debt is the monetary value of all liabilities an organisation owes to third-party sources, internal employees and shareholders. It can include short and long-term loans an organisation owes to banks and other lenders.

  • Total assets are the total number of resources an organisation controls. It can include machinery, patents, liquid money (cash), inventory and account receivable payments.

Related: What Are Accounts Receivable and How Does It Function?

Financial leverage

Financial leverage is a solvency ratio you can use to determine the number of an organisation's assets owned by its shareholders instead of its creditors or debt holders. It can also help you determine the impact of all interest-bearing and interest-free obligations an organisation has. Obligations are responsibilities an organisation has to pay external parties. They may be payments for loans or leases. The higher the financial leverage ratio is, the higher the leverage of an organisation and the riskier it is to invest in because of its high debt obligation.

The formula for financial leverage is:

Financial leverage ratio = total assets / total equity

Where:

  • Total assets are the total number of resources an organisation controls. It can include real estate, facilities, products and machinery to produce their goods and services.

  • Total equity is the combined monetary value of the organisation's accumulated earnings and money received from investors, minus the monetary value of its total liabilities that an owner puts into an organisation.

Proprietary ratio

This ratio can tell you the relationship between the funds of shareholders and the total assets of an organisation. It also represents the extent to which the lead staff of an organisation return shareholders' funds into the organisation's assets. The higher this ratio, the lower the leverage and the less financial risk for investors and the organisation itself. A higher ratio indicates that more shareholder funds are being used instead of debt holder funds or those from creditors. This means the organisation owns more of its assets than external parties.

The formula for the proprietary ratio is the inverse of the financial leverage ratio. You can represent the formula as:

Proprietary ratio = total equity / total assets

Where:

  • Total equity is the combined monetary value of the organisation's accumulated earnings and money received from investors, minus the monetary value of its total liabilities that an owner puts into an organisation.

  • Total assets are the total number of resources an organisation controls. It can include real estate, facilities, products and machinery to produce their goods and services.

Related: What Is Asset Management? (Plus Types and Benefits)

How are solvency ratios useful for businesses?

Businesses can use solvency ratios to check on their own financial status. If an organisation is confident in its short-term stability, using these ratios to determine its long-term financial stability, leverage and debt can help it plan for the future. This can also help the organisation prepare for any fluctuations in its earnings when paying off debt, allowing it to reinvest its own money in improving itself. Watching both short and long-term finances can help organisations operate efficiently with few disruptions because they can make accurate predictions.

How are solvency ratios useful for investors?

Assuming investors have access to an organisation's total debt, total equity and total assets, they can use the solvent ratios to determine how viable an organisation is for investing. If it looks like an organisation is going to become free of debts, it can be worth investing in it. If the organisation seems to struggle with its debts, obligations and liabilities or represents a high risk financially, it may be safer to avoid investing in it. This can help you choose organisations where you can responsibly invest your money or your clients' money.

Solvency ratios vs. liquidity ratios

The difference between solvency ratios and liquidity ratios is that solvency focuses on the long-term financial health of an organisation, while liquidity ratios focus on the short term financial health of an organisation. This means that both are excellent tools for you to utilise when predicting the value of an organisation. Paying attention to both can help you make better decisions with your time and money.

Tips for calculating solvency ratios

There are three main tips you can use when calculating solvency ratios:

  • Find the total debt, total equity and total assets of an organisation. When you find these values, you can also calculate their component values used in the solvency ratios.

  • Remember that solvency is for the long-term financial positions of organisations. While they're helpful for these calculations, other calculations can help you determine an organisation's short-term viability.

  • Evaluate an organisation's debt, equity and assets. Doing so can help you forecast the growth of an organisation because you understand how long it may be before the organisation is debt-free, liability-free and obligation-free.

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