Brief Definition
The solvency ratio is a key financial metric used to measure a company’s ability to meet its long-term debt obligations and remain financially healthy over the long term. A higher solvency ratio indicates a stronger ability to meet long-term debts, while a lower ratio may suggest potential financial instability.
Further Explanation
The solvency ratio is a key financial metric used to measure a company’s ability to meet its long-term debt obligations and remain financially healthy over the long term. It compares a company’s after-tax income, plus depreciation, to its total liabilities. A higher solvency ratio indicates a stronger ability to meet long-term debts, while a lower ratio may suggest potential financial instability.
Example:
The Debt to Equity Ratio is a common solvency ratio. It compares a company’s total liabilities to its shareholder equity, indicating how much debt is used to finance the company’s assets relative to the value of shareholders’ equity. The formula is:
Debt to Equity Ratio = Total Liabilities/Shareholder Equity
If a company has total liabilities of $500,000 and shareholder equity of $1,000,000, its Debt to Equity Ratio would be:
Debt to Equity Ratio – 500,000/1,000,000 = 0.5
This means the company has 50 cents of debt for every dollar of equity.