It’s important to not confuse Solvency with Liquidity. While both set of ratios measure the financial health of a company, they have notable differences. As previously explained, the Liquidity Ratios are used to determine a company’s ability to pay off its short-term debts (12 months and less). The Solvency Ratios measure the ability for a company to meet its long-term financial obligations.
In other words, the Liquidity Ratios measure the ability to quickly convert assets into cash, while the Solvency Ratios checks that the business owns more than it owes. The latter has a longer term emphasis.
Both set of ratios are important as while a company may have enough cash or near-cash available to pay its bills (Liquidity), it may not be in a position to pay-off its long term debt obligations if called upon to do so.
One of the key Solvency Ratio is the Interest Cover ratio, which measures the ability of a company to honour its interest obligations with the profit generated by its Operations:
Interest Cover = Operating Profit / Total Interest Expense
The higher the ratio, the better. A ratio below 2 could be a warning sign. A ratio below 1 indicates that the business does not generate enough profits from its operations to pay its interest obligations (let alone reimbursing the capital).
The other key Solvency Ratio is the Debt Ratio, which measures how the business finances its assets:
Debt Ratio = Total Liabilities / Total Assets
There are only two ways to finance the purchase of assets: either through Equity, or through Debt. A low Debt Ratio indicates that the assets are mainly financed through Equity (“Highly liquid”). A high Debt Ratio indicates that the assets are mainly financed through Debt (“Highly leveraged”). Beyond a certain point (which depends on the industry sector), a high Debt Ratio will affect the borrowing capacity of the business by reducing the amount that can be borrowed and/or by making it more expensive.
This concludes our blogs on the Financial Ratios. I hope you have found them to be helpful.