This article explains the Solvency Ratio in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is the Solvency Ratio?
The solvency ratio of an organization gives an insight into the ability of an organization to meet its financial obligations. Solvency also indicates how much the organization depends on its creditors and banks can use this when the organization applies for a credit facility.
Solvency Ratio formula
The solvency ratio is a calculation formula and solvency indicator that demonstrates the relationship between the various equity components. There are two ways to calculate the solvency ratio:
Solvency Ratio I = Equity* / Total Assets** x 100%
* = Equity is the capital that the entrepreneur has invested in the organization.
** = Total assets is the capital that is incorporated in the organization, these are the Equity, the Short-Term Liabilities (the capital that has to be repaid in the short- term, for instance a suppliers credit, creditors or overdraft facility) and the Long-Term Liabilities (long-term liabilities that can be repaid after more than one year).
In order to determine whether an organization is viable, the outcome should be between 25% and 40%.
This is of course dependent on the industry and type of undertaking.
This also says something about the financial health of an organization but this does not necessarily mean that they are going bankrupt.
The second manner is about the weighing of the assets with respect to the Total Liabilities.
The calculation is as follows:
Solvency Ratio II = Total Assets* / Total Liabilities** x 100%
* = Total Assets is the sum of assets of an organization. This is divided into current assets (these are the assets of a person, company or organization in which the capital is contributed for a period of less than one year). The current assets must be converted into money within one year. Examples of current assets are stock, receivables and liquid assets) and fixed assets (these are for example buildings, inventory, machines and plants and vehicles)
** = Total Liabilities are the total liabilities that are incorporated in the organization, these are the Short-Term Liabilities and the Long-Term Liabilities.
The higher the outcome in percentages the more solvent the organization is.
Now it’s your turn
What do you think? Do you recognize the explanation about the solvency ratio, or do you have anything to add? What do you believe are success factors that contribute to the practical application of this method?
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- Mendoza, E. G., & Ostry, J. D. (2008). International evidence on fiscal solvency: Is fiscal policy “responsible”?. Journal of Monetary Economics, 55(6), 1081-1093.
- Eling, M., Schmeiser, H., & Schmit, J. T. (2007). The Solvency II process: Overview and critical analysis. Risk Management and Insurance Review, 10(1), 69-85.
- Taffler, R. J. (1983). The assessment of company solvency and performance using a statistical model. Accounting and Business Research, 13(52), 295-308.
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