Investing in a company is a big decision that needs to be backed up by certain financial principles. Solvency of a company is one such principle derived through several mathematical calculations. It is defined as a company’s ability to meet long-term fixed expenses. When a company is solvent, it is considered financially healthy and has the potential to grow further.
When determining a company’s solvency, one should refer to its balance sheet, statement of cash flow, and the income statement. The annual report of a company should be a good source for this information and even if it is not available, a potential investor should be able to request the company to provide up-to-date financial statements for analysis. Following are some of the ratios that are useful to determine the solvency of most companies.
Solvency ratio (Solvency margin)
While calculating the solvency ratio, one should consider the depreciation and therefore the formula should read as dividing the value gained after summating the income before taxes and the depreciation from the total liabilities. According to the Farlex financial dictionary, most solvent companies should be able to function effectively with a solvency ratio of around 20% while this could be higher or lower from one organization to another. The importance of calculating the solvency ratio is that, it considers the need for a company to replace or renovate the ageing equipment or fixed assets over time and therefore includes the additional expenses that may arise in the future. Therefore, the solvency ratio should reflect a realistic picture regarding the company’s financial soundness to a potential investor.
By dividing the total liabilities by the total assets of a company, one shall derive the ‘debt-to-total assets ratio’ and for a sound investment, one should be looking for companies with a low ‘debt-to-total assets ratio’. In general, this ratio tells the investor the dollar amount of a company’s assets financed by its creditors. As these debts needs to be settled using the company’s cash flow at a given future date, realizing the enormity of the company’s debt should be valuable information to the potential investors.
Capital expenditure ratio
In order to understand the company’s ability to invest on the production, one should calculate the capital-expenditure ratio. It can be done by dividing the cash provided by the operations from the capital expenditure of the company. Having a higher capital-expenditure ratio should present a positive outcome regarding the company’s solvency.
Interest cover ratio
The interest cover ratio reflects the effectiveness of the company’s operational income before taxes and interest payments. In order to calculate the same, one should total the interest payments due for a particular year and compare that value with the operational income before taxes, and interest pay. This also reflects on the company’s long-term solvency, as continued reliable income should guarantee timely payments of existing debt.
The ratios mentioned above are used to measure a company’s solvency. One should always keep in mind that the necessary solvency margins and the ways to calculate the relevant ratios could vary from one organization to another depending on the type of business and the trends relevant to that sector.