What Are Solvency Ratios?

Knowledge of ratios and other important financial metrics can give individual investors an advantage when it comes to choosing a stock. These ratios can help investors understand how a company might react to shifts in industry, financial and economic environments. Financial ratio analysis relies on financial documents such as the balance sheet, income statement and cash flow statement to study the past as well as develop a feel for a stock’s attractiveness measured on various factors.

You can use ratios to evaluate the viability of a company and compare it to other companies in similar industries. However, keep in mind that these ratios are interrelated and should be examined together rather than independently.

One specific group of metrics you’ll want to familiarize yourself with are solvency ratios. We will delve into what solvency ratios tell investors about a company and how you can use these common metrics to determine if you should invest in the company’s stock or not.

What Does Financial Solvency Mean?

Solvency is the ability of a company to meet its long-term debts and other financial obligations. Financial solvency ratios help gauge a company’s ability to manage overall operations now as well as into the foreseeable future. Being able to meet long-term financial commitments indicates that the company has healthy cash management practices and successful business operations. It also ensures that a company will be able to continue operating.

A potential investor will want to look at a company’s financial solvency and liquidity ratios together, so they get the complete picture when analyzing the financial health of a stock or other security. Additionally, investors should evaluate other key investment metrics such as profitability and activity ratios.

What Are Solvency Ratios?

There are four main solvency ratios you should look at when conducting analysis on a company’s financial health, including:

• Debt-to-assets ratio: measures the percentage of a company’s total assets that is financed by debt
• Debt-to-capital ratio: measures the amount of a company’s total capital (long-term debt plus equity) that is provided by debt
• Debt-to-equity ratio: measures the amount of long-term debt a firm has compared to the total shareholder’s equity (total assets less total liabilities)
• Interest coverage ratio: measures a company’s earnings or cash flows generated compared to its interest expense

These common solvency ratios help individual investors understand the strength of a company’s balance sheet before purchasing its stock. Doing research and looking at solvency ratios helps lower the chances of investing in a company that could go bankrupt in the near future.

What Do Solvency Ratios Tell Us?

An investor can use solvency ratios to protect their potential investments. These ratios analyze the company’s ability to meet its long-term debt obligations, such as interest payments on bonds they’ve issued. Solvency ratios also determine whether a company’s cash flow, earnings or assets are sufficient to meet its long-term liabilities.

With the help of these ratios, the shareholder can easily keep an eye on downward trends that could suggest the potential for bankruptcy in the future. They also help analysts keep a close eye on how much debt a company is taking on in comparison to its assets and earnings, because a solvent company is one that owns more than it owes. This is especially useful when investing in mid- and small-cap companies that don’t have as much research and analysis coverage – forcing you to make judgements on your own.

What Are the Limitations of Solvency Ratios?

There are advantages of and limitations to looking at solvency ratios when determining a company’s financial health. If a company has a low amount of debt or none at all, it could still have major issues with cash management practices as well as increased accounts payable. In these cases, its solvency may not be as solid as would be indicated by metrics that only include debts such as interest and loans.

In addition to analyzing a company’s solvency ratios, investors should determine if the security is under- or overvalued. You will also need to look at how fast the company is growing and if it has a strong business model—especially when it comes to mid- and small-cap companies. As with any financial analysis, you will want to look at numerous financial metrics and ratios before making an informed decision.

What Constitutes a Good Solvency Ratio?

Before you look online to see what a good solvency ratio is, you will want to make sure you are comparing companies in the same industry. For example, you’d want to analyze a stock such as Shopify Inc. (SHOP) by looking at another firm in the e-commerce sector such as Bigcommerce Holdings Inc. (BIGC).

However, the higher a company’s solvency ratio, the more likely it is to meet its financial obligations. Companies with lower solvency ratios could have an increased risk of bankruptcy or need to find sources of funding to meet their obligations. This is because the lower a company’s solvency ratio, the greater the probability that the company might default on its debt obligations or struggle to cover them in the future.

Note one industry exception: These ratios cannot be used with banks and other financial firms since solvency carries a much different meaning for them.

Where to Find Solvency Ratios

So now that you know what solvency ratios are, you may wonder where you can find them. On the AAII website, you can type any stock ticker into the search bar to view a long list of financial metrics and other information. Then, click on the “Financials” tab to view total current assets, short-term and long-term debt, as well as current liabilities for the last five years for that security.

In the A+ Investor Custom Stock Screener, you can also filter by long-term debt to equity. This filter indicates what proportion of the firm’s capital is derived from debt as compared to equity. A higher percentage of debt compared to equity increases the risk of volatility of earnings as well as the probability that the firm will not be able to make its interest payments and default on its debt.

Using Solvency Ratios to Invest

Knowing the debt level of a company can help you more fully understand its capital structure, how it funds its assets and how easily it can meet its future obligations. It is key to understand how to calculate solvency ratios such as debt-to-assets, debt-to-equity, debt-to-capital and interest coverage.

When used properly, debt can allow a company to earn a higher level of profits for a given level of owner’s equity. However, interest on debt must be paid whether or not a company is profitable, so too much debt may force a company into bankruptcy if cash flow dries up.

As an individual investor, you need to have the right tools and resources to purchase and sell securities with confidence. With A+ Investor, or our AAII Platinum bundle, you can have countless rankings, screens, commentary and grades to compare stocks or funds with ease.

Start analyzing your stocks’ solvency ratios and overall performance today with A+ Investor.