This page covers practice CPA questions that covers financial ratios including solvency ratio.
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BREAKING DOWN ‘Solvency Ratio’
The solvency ratio is only one of the metrics used to determine whether a company can stay solvent. Other solvency ratios include debt to equity, total debt to total assets, and interest coverage ratios.
However, the solvency ratio is a comprehensive measure of solvency, as it measures cash flow – rather than net income – by including depreciation to assess a company’s capacity to stay afloat. It measures this cash flow capacity in relation to all liabilities, rather than only short-term debt. This way, solvency ratios assesses a company’s long-term health by evaluating its long-term debt and the interest on that debt.
As a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound, however, solvency ratios vary from industry to industry. A company’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation. For example, companies in debt-heavy industries like utilities and pipelines may have lower solvency ratios than those in sectors such as technology. To make an apples-to-apples comparison, the solvency ratio should be compared for all utility companies, for example, to get a true picture of relative solvency.
The solvency ratio is calculated by dividing a company’s cash flow or after-tax net operating income by its total debt obligations. The cash flow is derived by adding non-cash expenses or depreciation back to net income.
Measuring cash flow rather than net income is a better determinant of solvency, especially for companies that incur large amounts of depreciation for their assets but have low levels of actual profitability. Similarly, assessing a company’s ability to meet all its obligations provides a more accurate picture of solvency. A company may have a low debt amount, but if its cash management practices are poor and accounts payable is surging as a result, its solvency position may not be as solid as would be indicated by measures that include only debt.
Solvency ratio, with regard to an insurance company, means the size of its capital relative to the premiums written, and measures the risk an insurer faces of claims it cannot cover.