What Are Solvency Ratios?

Solvency ratios are primarily used to measure a company's ability to meet its 澳洲幸运5官方开奖结果体彩网:long-term obligations. In general, a 澳洲幸运5官方开奖结果体彩网:solvency ratio measures the size of a company's ꧂profitability and compares꧙ it to its obligations.

By interpreting a solvency ratio, an analyst or investor can gain insight into how likely a company will be to continue meeting its debt obligations. A stronger or higher ratio indicates fina🍸ncial strength. In stark contrast, a lower ratio, or one on the weak side, could indicate financial struggles in the future.

A primary solvency ratio is usually calculated as follows and measures a firm's cash-based profitability as a percentage of its total long-term obligations.

Understanding Solvency Ratios

Solvency ratios indicate a company's 澳洲幸运5官方开奖结果体彩网:financial health iﷺn the context of 🅰its debt obligations. As you might imagine, there are a number of different ways to measure financial health.

Debt to Equity

澳洲幸运5官方开奖结果体彩网:Debt to equity (D/E) is a fundamental indicator of the amount of leverage a firm is using. Debt generally refers to long-term debt, though cash not needed to run a firm’s operations could be netted out of total long-term debt to give a net debt figure.

Equity refers to 澳洲幸运5官方开奖结果体彩网:shareholders’ equity, or 澳洲幸运5官方开奖结果体彩网:book value, which can be found 澳洲幸运5官方开奖结果体彩网:on the balance sheet. Book value 澳洲幸运5官方开奖结果体彩网:is a historical figure that would ideally be written up (or down) to its 澳洲幸运5官方开奖结果体彩网:fair market value. But using what the company reports present𝓀s a quick and readily availa💛ble figure to use for measurement.

Debt to Assets

澳洲幸运5官方开奖结果体彩网:Debt to assets (D/A) is a closely related measure that also helps an analyst or investor measure leverage on the balance sheet. Since assets minus liabilities equals book value, using two or three of these items will provide a great level of insꦯight into financial health.

More complicated solvency ratios include 澳洲幸运5官方开奖结果体彩网:times interest earned, which is used to measure a company's ability to meet its debt obligations. It is calculated by taking a company's 澳洲幸运5官方开奖结果体彩网:earnings before interest and taxes (EBIT) and dividing it by the total 澳洲幸运5官方开奖结果体彩网:interest expense from long-term debt. It specifically measures how many times a company can cover its interest charges🔥 on a pretax basis. Interest coverage is another more general term used for this ratio.

Solvency vs. Liquidity Ratios

The solvency ratio measures a company's ability to meet its long-term obligations as the formula above indicates. 澳洲幸运5官方开奖结果体彩网:Liquidity ratios measure short-term financial health. The 澳洲幸运5官方开奖结果体彩网:current ratio and 澳洲幸运5官方开奖结果体彩网:quick ratio measure a company's ability to cover short-term liabilities with liquid (maturities of a year or less) assets. These include 澳洲幸运5官方开奖结果体彩网:cash and cash equivalents, 澳洲幸运5官方开奖结果体彩网:marketable securities, and 澳洲幸运5官方开奖结果体彩网:accounts receivable.

The 澳洲幸运5官方开奖结果体彩网:short-term debt figures include payables or inventories that need to be paid for. Basically, solvency ratios look at long-term debt obligations while liquidity ratios loo﷽k at work❀ing capital items on a fi🦩rm’s balance sheet. In liquidity ratios, assets are part of the numerator and liabiliti🐽es are in the denominator.

What These Ratios Tell an Investor

Solvency ratios are different for different firms in different industries. For instance, food and beverage firms, as well as other 澳洲幸运5官方开奖结果体彩网:consumer staples, can generally sustain higher 澳洲幸运5官方开奖结果体彩网:debt loads given their profi🍷t levels are less susceptible to economic fluctuations.

In stark contrast, cyclical firms 澳洲幸运5官方开奖结果体彩网:must be more conservative because a 澳洲幸运5官方开奖结果体彩网:recession can hamper their profitability and leave less cushion to cover debt 澳洲幸运5官方开奖结果体彩网:repayments and related interest expenses during a downtꦗurn. Financial firms are subject to varying state and national regulations that stipulate solvency ratios. Falling below certain thresholds could bring the wrath of regulators and untimely requests to raise capital and shore up low ratios.

Acceptable solvency ratios vary from industry to industry, but as a general 澳洲幸运5官方开奖结果体彩网:rule of thumb, a solvency ratio of less than 20% or 30% is considered financially healthy. The lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

Looking at some of the ratios mentioned above, a debt-to-assets ratio above 50% could be cause for concern. A debt-to-equity ratio above 66% is cause for further investigation, especially for a firm that operates in a 澳洲幸运5官方开奖结果体彩网:cyclical industry. A lower ratio is better when debt is in the numerator, and a higher r👍atio is better when assets are part of the numerator. Overall, a higher level of assets, or of profitability compared to debt, is a good thing.

Industry-Specific Examples

An analysis of European insurance firms by consulting firm Bain highlights how solvency ratios affect firms and their ability to survive, how they put investors and customers at ease about their financial health, and how the regulatory environment comes into play. 

The report details that the 澳洲幸运5官方开奖结果体彩网:European Union is implementing more stringent solvency 澳洲幸运5官方开奖结果体彩网:standards for insurance firms since the 澳洲幸运5官方开奖结果体彩网:Great Recession. The rules are known as Solvency II and stipulate higher standards for property and casualty insurers, and life and health insurers. Bain concluded that Solvency II “exposes considerable weaknesses in the solvency ra🎐tios and risk-adjusted profitability of European insurers.”

The key solvency ratio is assets to equity, which measures how well an insurer’s assets, including its cash and investments, are covered by solvency capital, which is a specialized book value measure that consists of capital readily available to be used in a downturn. For instance, it might include assets, such as stocks and bonds, that can be sold quickly if financial conditions deteriorate rapidly as they did during the 澳洲幸运5官方开奖结果体彩网:credit crisis.

A Real-World Example

MetLife (NYSE: MET) is one of the largest 澳洲幸运5官方开奖结果体彩网:life insurance firms in the world. As of Sept. 30, 2021, MetLife's debt-to-equity ratio of around 20%. This is a💮n average debt level compared to other fir𝓡ms in the industry, meaning roughly half of rivals have a higher ratio and the other half have a lower ratio.

The ratio of 澳洲幸运5官方开奖结果体彩网:total liabilities to total assets stands at 1.1x, which doesn’t compare as well as its debt-to-equity ratio because approximately two-thirds of the industry has a lower ratio. MetLife’s liquidity ratios are comparatively worse and at the bottom of the industry when looking at its current ratio (0.09 times). But this isn’t much of a concern given the firm has one of the large🌠st balance sheets in the insurance industry and is generally able to fund i💜ts near-term obligations.

Overall, from a solvency perspective, MetLife should easily be able to fund its long-term term debts as well as the interest payments on its debt. However, its low current ratio su🍌ggests there could be some immediate liquidity issues, as opposed to long-term solvency ones.

Context Is Key

Solvency ratios are extremely useful in helping analyze a firm’s ability to meet its long-term obligations. But like most financial ratios, they must be usღed in the context of an overall company analysis.

Investors need to look at overall investment appeal and decide whether a security is under or 澳洲幸运5官方开奖结果体彩网:overvalued. Debt hoꦐlders and regulators mi♏ght be more interested in solvency analysis, but they still need to look at a firm’s overall financial profile, how fast it is growing, and whether the firm is well-run overall.

The Bottom Line

澳洲幸运5官方开奖结果体彩网:Credit analysts and regulators have a great interest in analyzing a firm’s solvency ratios. Other investors should use them🌱 as part of an overall toolkit to investigate a company and its invest🤪ment prospects.