Solvency ratio is a key metric used to measure an enterprise’s ability to meet its debt and other obligations. The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. Generally, a lower solvency ratio of a company reflects a higher probability of the company being on default with its debt obligations. “The lower a company’s solvency ratio, the greater the probability that it will default on its debt obligations.”
The measure is usually calculated as follows –
Solvency Ratio =
[Net Income (or After – Tax Profit) + Depreciation] / [Short-Term Liabilities + Long-term Liabilities]
Solvency ratio is one of the various ratios used to measure the ability of a company to meet its long-term debts. The ratio is most commonly used by current and prospective lenders. The ratio compares an approximation of cash flows to liabilities and is derived from the information stated in a company’s income statement and balance sheet. Moreover, the solvency ratio quantifies the size of a company’s after-tax income, not counting non-cash depreciation expenses, as contrasted to the total debt obligations of the firm. Also, it provides an assessment of the likelihood of a company to continue congregating its debt obligations.