Solvency Ratios: What is it and how to calculate it?

The solvency ratio is the ratio between the company's total assets and total liabilities. This financial ratio answers the question... can the company pay all its debts to third parties today, with the assets and rights it owns?

What is the Solvency Ratio and what is it used for?

In general terms, the solvency ratio corresponds to the ratio between the company's total assets and its total liabilities, i.e., it measures the company's ability to meet its long-term debts.  

The process of assessing long-term solvency is different from the assessment of short-term liquidity, both in terms of the time horizon and the basic variables used. While the short-term analysis focuses on liquidity, the long-term analysis focuses on earnings as a fundamental element for the generation of long-term solvency and liquidity.

A company is solvent when it is able to pay its total obligations to third parties with all or less of its assets and rights.

Solvency Ratio Calculation Formula

There are more complex formulas and other simple ones, but in general terms, the solvency ratio is calculated as follows:

Solvency = Total Assets / Total Liabilities

Disaggregating the formula:

Solvency = (Current Assets + Non-Current Assets) / (Current Liabilities + Non-Current Liabilities)

Solvency Ratio Interpretation

For the interpretation of the solvency ratio it is necessary to think about the following: what would happen if the company decides to close today, can it pay all its debts to third parties? Or to put it another way, if the company decides to get out of debt with third parties, will all its assets be enough to pay the debt?

Optimal values for companies

The ideal or optimum value of the solvency ratio is a result with a value between 1 and 2, i.e., that the total assets exceed the total liabilities of the company, but not more than twice.

If the value of the solvency ratio is less than 1, the company does not have the capacity to pay all its debts to third parties with all its assets. In other words, in the long term, what today is a solvency problem may become a liquidity problem.

If the value of the solvency ratio is greater than 2, the company has an excess of wasted resources. It could increase its installed capacity, enter new markets, distribute profits, among other activities to take advantage of available resources.

The property, plant and equipment ratio

Along with the simple solvency formula, the company's property, plant and equipment ratio is also evaluated to assess how many assets that are difficult to convert into cash the company owns. While it is an important backing or guarantee to have real estate and vehicles, for example, it is not possible to convert them into cash or its equivalent immediately.

Fixed Assets = Non-current or fixed assets / Total Assets

Ideally, fixed assets should not exceed 0.5, i.e., fixed assets should not exceed 50% of total assets, but this depends on the line of business, operating needs, among others.

The importance of Solvency Ratio in risk management

Financial ratios are useful for efficient and timely decision making by stakeholders, as are the techniques of horizontal and vertical analysis of financial statements.

Specifically, the solvency ratio is extremely useful in third party risk management analysis. For example:

• A bank or finance company that must evaluate the possibility of lending money to the company will analyze the solvency to know the possibility of collecting that debt in the long term.
• An investor who needs to merge with the company or simply enter into joint ventures or collaboration agreements will analyze the company's solvency, in order to know whether the company is in a position to face short and long-term debts.
• The government, when granting subsidies or financing plans for tax or social security debts, will analyze how compliant the company can be in the long term.
• A frequent supplier of the company, you need to know if the company would have sufficient resources to pay the debt in a fortuitous event or force majeure situation in which the company would have to close its doors.

Thus, it is possible to conclude that the solvency ratio analysis in particular provides valuable information for third party decision making.

When a KYC or Due Diligence analysis is to be performed from the company to third parties, requesting information on the solvency of that third party will provide reasonable security in the collection of the rights we acquire over that third party, for example: large customers. 

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