A business owner and his management team have a duty to keep a close eye on the financial obligations. One of the most important aspects is called the solvency ratios analysis. It is a major part of the financial status and it shows if the business can afford to pay debt.
This is a method to calculate a Company’s possibility to keep up with the debt and other similar obligations. Solvency ratios analysis is a way for the business to tell if the current revenue is enough to satisfy liabilities. This includes not just the ones that are current, but future ones as well. To make it simple, it should be kept in balance, not too high but not too low.
The formula is the following:
Solvency Ratio = Net Income+Depreciation/(Short-Term Liabilities+Long-term Liabilities)
When conducting solvency ratios analysis, it is important to take into consideration all of the Company’s possessions. This includes cash and everything that can be liquidated. A company with a high solvency score will be viewed by creditors and banks as more likely to pay their debt. In addition to this, a company with a low solvency score will be viewed as a potential risk to creditors and banks. There is no good ratio, as it depends on the industry on which the business is working on. Furthermore, a business with a percentage of around 20% is considered as healthy as an average basis.
Many people confuse Solvency ratios with liquidity ratios. It is good to have both in good standing. However, Liquidity ratios, state if a business is capable of dealing with liabilities for short to come. Solvency ratios analysis refer to the business being capable of dealing with liabilities for long-term periods.
It is vital for any business to keep an eye on these percentages. Making sure that it stays in normal parameters will help the business to avoid bankruptcy. In addition to this, knowing the ratio will help the business owners make decisions for the future.
Calculating this percentage helps banks and creditors to verify if a specific business is trustworthy. A business with low ratio will usually not get any financial support from banks. This is because the fact that there is a low chance for the business to pay back the loan. Knowing the ratio allows business owners to make important decisions for the near future which will benefit them on the long run. Not keeping a close eye on this percentage can easily lead to bankruptcy.
For now it is clear that a company with an unbalanced ratio will lose its trust from banks and other similar financial institutions. The reason for this is because the business cannot promise to pay the loan, or at least on time. Imagine that you are an investor who is looking to partner with a business. Your main choice would be a business that is stable from a ratio point of view. However, the business in question may change its percentage in the future and prove to be an unreliable business. This implies that it is best to take a look back in history. The longer the business has kept its ratio in balance, the higher chances that it will keep it that way for a long time. Some may say that this will affect new businesses from gaining loans from investors and banks, since they haven’t proven their worth.
There are several types of solvency ratios analysis in existence, which can be used to calculate various points of a business. The following are the most known types that businesses use more often:
- Debt to equity
This type of ratio is a method to calculate the debt vs the shareholder equity. The formula is simple; first you calculate exactly the total amount of liabilities and divide it with the total amount of the shareholders equity.
Debt to Equity = Liabilities/Shareholder equity
It is clear that a business with a high ratio means that it’s stable from a financial point of view. However a business with a high debt to equity ratio means that the business exaggerated when using its debt to support itself financially. Worldwide, interest amounts keep on rising and for this reason many companies are suffering from unexpected changes in profit. In order for companies to avoid insolvency, they must keep an eye on various options for costs. As well as focus on ways to lower the amount of debt and increase the amount of profit.
- Total debt to total assets
This ratio explains the ratio between short term and long term liabilities in comparison to everything the company owns. As far as the formula for it goes, it is quite simple. You must take the total amount of short and long term liabilities and divide with the total amount of assets. In this case, a business with a total debt to total assets ratio is higher than usual, will lose its trust from investors and banks.
Total debt to total assets = Short and long term liabilities/Assets
When a company is measuring the total debt to total assets ratio, it is vital to add the levels of leverage. Within a company, some liabilities can be discussable for example the amount of employee bonuses, which can be modified. Companies with total debt to total assets ratio high and uncontrollably, will usually have high leverage. This leads to the company to be frozen without any possibility of getting out of debt. One way for companies affected by this to escape this never ending circle is to increase the value of their assets or forget about profit and focus on paying debt.
- Interest Coverage Ratios
This type of ratio interests companies with high amounts of debt. Interest coverage ratios are a method to calculate the total amount of interest payments. These amounts appear when a company is not paying its debt on time. In order to calculate the interest coverage ratio you must take the total amount of earnings before tax and profit and divide them by the interest expenses.
Interest coverage ratios = (Earnings(before tax and profit))/Interest expenses
On average, a business with an interest coverage ratio of 1.5 or even less will lose its credibility to investors and banks. For a business that is in this situation to make a comeback, they should focus on paying debt and increase profit.
Overall, solvency ratios analysis affect a business in two major ways. First of all, they lead to banks and investors to lose trust in the company and refuse any loans. Second after this and the most important is that they measure the chances for the company to survive the future. It is vital for any business owner to often calculate the ratios, because it helps them make important decisions.
- Keeping ratios under control allows the business to invest in new assets which will help it grow
- Allow the management team to focus on more important things such as development
- Keeping up with debts
- Increase the chances that the business will stay on the market for a long time
Solvency ratios analysis in good standing will help the business to attract new partners and investors. It also helps to increase the profit amount, as low as it might be but at least it doesn’t go towards paying debt.
- High amount of debt and in some cases, additional interest
- The company’s assets at the risk of being taken by the bank
- The earnings goes to the bank instead of going towards further investment
- Reduced profit in cases of high debt amounts
It is critical for business owners and management team to focus on clearing debts fast enough to make room for profit. A business with low solvency ratios will lose in the long run.
Now that everything is clear about these percentages, we should remind ourselves of the most important aspects. Solvency ratios analysis are best if they are kept high. This will help the company to gain new investors and partners. It will also help them increase profit and with this new assets. Lastly, it is very important for every business no matter how large it is, to always keep an eye on the ratios.