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What is the Solvency Ratio and How Do You Use It?

Posted by Jim Secord on August 12, 2015 at 1:48 PM

As you may know, there are plenty of financial ratios you can use to help you assess your small business' financial health and position within the market. Just recently, we took a look at the Operating Cash Flow Margin  and Return on Assets. Another great way to check in with your business's financial standing is with the Solvency Ratio.


What is Solvency?

If you're new to the small business accounting game, you might be wondering what solvency is in the first place. In a nutshell, solvency refers to your company's ability to meet its long-term financial obligations. This is similar to liquidity, although where solvency deals with long-term financial commitments, liquidity deals with paying off a company's bills in the short-term.


A quick way to think about solvency is to ask yourself whether or not the business owns more than it owes. Said differently, does the business have positive net worth and is it able to manage its long-term debt load? Solvency and liquidity are both very important measures no matter the size of your business, but paying attention to solvency can give you a more complete and future-focused picture of your company's financial health.


Let's take a look at how to calculate the solvency ratio.

 

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Calculating the Solvency Ratio

The formula used to calculate solvency is:


(Net Income + Depreciation) / (Short-term Liabilities + Long-term Liabilities)


Let's take a closer look at the numerator of this formula. Net income refers to the company's profits or earnings after taxes, and is found at the bottom of your income statement (that's why net income is sometimes called the "bottom line").


Added to this figure is depreciation, which is essentially the decrease in value of the company's assets over time. Including depreciation makes this calculation a more complete measure of solvency, as it allows you to take into account cash flows and not just income.


What Can the Solvency Ratio Tell Us?

The solvency ratio is one of the main financial ratios that lenders will look at when trying to determine a company's creditworthiness. So if you're looking to take out a small business loan or get a line of credit, your business' solvency can play a part in making that happen.


As we mentioned before, liquidity is an important measure of your company's ability to stay afloat in the near future, but if you want to plot a course further ahead and spot concerns before they snowball, you're going to want to pay attention to your solvency. Getting familiar with the solvency ratio is a great place to start.

 

Topics: Accounting