Solvency Ratios: Definition and Calculation

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Understanding Solvency Ratios and Their Importance in Business Financing

In growth objectives, a company manager needs to look for sources of financing to develop his activity. In addition to the profits generated, one of these sources of financing is based on debt. It is this ability to pay all obligations, whether short-term or long-term, that we place under the term of “solvency.”

What is Solvency?

Indeed, when a company is sure that it can pay all its debts when they come due, it says it is solvent. To find out, it is important to resort to solvency ratios.

Key Questions Regarding Solvency Ratios

What do they correspond to?
What are the existing types of ratios?
How to calculate them?
What interests do they have in the relationship with potential investors or creditors?
Is it essential to distinguish between short-term and long-term ratios?
In this article, Agicap tells you everything about solvency ratios.

Solvency Ratios: Definition

Solvency ratios make it possible to estimate the financial situation of a company, focusing only on its ability to meet its long-term obligations. They include interest and principal payments on bank loans or bonds.

Why are solvency ratios important?

These ratios are closely monitored by investors to assess a company’s ability to meet its commitments and help it make decisions in its investment strategy. Ultimately, it is a question of whether the company has sufficient cash flows to cover payments related to long-term debt obligations.

Types of Solvency Ratios and How to Calculate Them

General Solvency Ratio

The objective of this first solvency ratio is to estimate the ability of a company to repay in the long term.
Formula:
General solvency ratio = shareholders’ equity / total liabilities

The Repayment Capacity

The repayment capacity evaluates the amount of annual debts in relation to the available resources of the company.
Formula:
Repayment capacity = annual self-financing capacity (CAF) / total annuities of repayment of medium-term loans

The Financial Autonomy Ratio

This ratio is used to estimate the funds that a company can draw from its financing.
Formula:
Financial autonomy ratio = equity/balance sheet total

The General Liquidity Ratio

This ratio indicates the ability of a company to cover its current liabilities with its current assets.
Formula:
General liquidity ratio = current assets / current liabilities

The Long-Term Liquidity Ratio

This ratio helps assess long-term repayment capacity.
Formula:
Long-term liquidity ratio = fixed assets / fixed liabilities

The Debt Coverage Ratio

This ratio verifies if the company generates enough operating margin to meet its repayments.
Formula:
Debt coverage ratio = gross operating surplus / annual borrowing and leasing

What Are Solvency Ratios For?

The main objective of solvency ratios is based on the assessment of the long-term financial health of a company. They measure a company’s ability to pay its debts and other financial obligations with its cash flows.

Advantages of Solvency Ratios

These ratios offer the advantage of:

Present a financial situation at a given moment in an accounting period.
Control the risks.
Reduce the level of receivables.

The Six Common Solvency Ratios

There are six ratios commonly used to assess the economic situation of a company:

General solvency ratio
Repayment capacity
Financial autonomy ratio
General liquidity ratio
Long-term liquidity ratio
Debt coverage ratio

Solvency Ratios and Financial Institutions

Calculating the solvency ratios remains interesting for an executive, of course, but the results are mainly used to facilitate a loan application to potential investors, like loan organizations.

The Other Ratios of Financial Analysis

A financial analyst must compute additional ratios in addition to solvency ratios in order to obtain a more accurate picture of a company’s financial status.