Solvency Ratio
What is Solvency Ratio?
Solvency ratio is an accounting formula to determine whether a company can or cannot service long-term debt. It indicates the extent to which a company is able to service debt through assets or revenues and thus, in the long term, whether healthy or unhealthy financially. It's really a test: the more solvent the company, the healthier; lower, and one will be able to find it difficult to service debt.
How is it Calculated?
There are some different methods for computing the solvency ratio, but one of the most popular formulas is:
Solvency Ratio = (Net Income + Depreciation) ÷ Total Liabilities
- Net Income: Income of the company after removing expenses and taxes.
- Depreciation: Non-cash expense recovered in order to reverse cash flow.
- Total Liabilities: Total short-term and long-term liabilities.
Another method is using total assets divided by total liabilities:
Solvency Ratio = Total Liabilities / Total Assets
Assume that a company has net profit of ₹10 crore, total liabilities of ₹40 crore, and depreciation of ₹2 crore. Its solvency ratio will be (₹10 crore + ₹2 crore) / ₹40 crore = 0.3 or 30%. Anything above 20% will generally be okay, although that also depends on the industry.
Why It Matters?
Solvency ratio informs investors, creditors, and analysts if a firm will live long. For Indian companies, who borrow funds in the most general sense by issuing loans or bonds, a good solvency ratio guarantees the stakeholders that the company will pay back the debt without becoming bankrupt. It is especially suitable in manufacturing or infrastructure industry, which require huge capital investment.
Examples
- Textile Company: A textile company with ₹15 crore net income, ₹5 crore depreciation, and ₹50 crore liabilities in Gujarat has a solvency ratio of (₹15 crore + ₹5 crore) ÷ ₹50 crore = 40%, which is good.
- Real Estate Developer: A Mumbai developer with. net. profits. of. ₹8. crore, depreciation of ₹3 crore, and liabilities of ₹100 crore has a solvency ratio of (₹8 crore + ₹3 crore) ÷ ₹100 crore = 11%, reflecting likely issues. regarding. the. ability. to. retire. debt.
- IT Company: IT firm of Bengaluru with asset worth ₹200 crores and liabilities of ₹50 crores has a solvency ratio of ₹200 crore ÷ ₹50 crore = 4 (or 400%), which is good because it is relatively not in debt.
Key Insights
- High Ratio: Indicates the ability of the company in settling the debt comfortably, characteristic of industries having a condition of excess in cash like IT or Indian pharma.
- Low Ratio: Shows higher possibilities of default, characteristic of highly debt-based businesses like telecom or real estate.
- Industry Variation: Average values differ from industry to industry. A 20% ratio may be acceptable for manufacturing but not for technology firms.
Advantages of Applying Solvency Ratio
- Long-Term Orientation: Focuses on whether a firm will last much, much longer than short-term concerns.
- Risk Analysis: Help creditors and investors make an estimate of the likelihood of debt repayment.
- Comparability: Enforces comparability with competitors, where feasible in India's heterogenous environment.
Limitations
- Limited Scope: Applies only to debt, without any relation with other drivers like cash flows or state of market.
- Accounting Differences:** Indian alternative accounting may impact net income or assets and hence mislead ratios.
- Static Perception: No one ratio will be able to capture dynamic change, e.g., future maturities of debt or new sources of revenue.
