Solvency Analysis

Solvency Analysis
/ sɒlvənsi əˈ
næləsɪs| noun
Definition: Solvency analysis is the process whereby it is analyzed whether the company is
able to meet its long-term obligations. In other words, analyzing the firm’s ability to pay its
long-term financial obligations along with the interest associated with the debt on time is
referred as solvency analysis.
Overview
Every organization procures some funds from various outside sources on which they have to
pay interest or rewards such as dividend on equity capital. To assess the company’s ability to
repay the debt or interest which is of long-term nature is known as solvency analysis. When the
company’s ability to pay its short-term obligations is assessed or evaluated then it is called as
liquidity analysis. The purpose of solvency analysis is to prove that the business can pay the
interest on timely basis and is also capable to make payment of the principle amount when debt
is matured.
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The solvency analysis is a part of financial analysis. The solvency of the company can be
broadly determined by two factors such as company’s current assets and company’s current
liabilities. The working capital of the company reveals the exact position of the company’s short-
term solvency as company is capable of paying its debt until its current liabilities exceeds its
current assets. The long term solvency of the company can be assessed by indicators such as
present net worth, equity debt ratio; loan repayment scheduled and interest coverage.
Example of Solvency Analysis:
The solvency ratio is equivalent to the ratio between the net income and depreciation to the
total liabilities. Total liabilities include both short-term liabilities as well as long term liabilities.
The picture below shows the expression of solvency ratio:
Let us compute the solvency of XYZ Company which is as follows:
Net income $60,000

Depreciation $10,000
Short-term liabilities $90,000
Long-term liabilities $135,000
Total liabilities $90,000+$135,000=$225,000
Solvency ($60,000-$10,000)/$225,000=22.22%
The solvency ratio of the company XYZ is 22.22% which depicts strong solvency of the
company along with good financial health. If company continues to earn such returns then the
company will be able to repay its debt within 5 years or less.
Ways to do Solvency Analysis:
Solvency ratios provide key metrics to assess whether the company is capable of meeting its
long-term and short-term obligations on timely basis. Following are the solvency ratios:
 Debt-to-Equity Ratio: Debt-to-equity ratio measures the debt capital which company
procures from outside sources as compared to the proportion of equity capital. This ratio
can be calculated by using following formula:
This ratio indicates the company’s paying capacity. The higher ratio indicates the weaker
solvency of the company.
 Debt-to-Capital Ratio: Debt-to-capital ratio measures the percentage of debt to the

total capital of the company. This ratio can be calculated by using following formula:
The higher ratio indicates the weaker solvency along higher financial risk.
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Debt-to-Asset Ratio: Debt-to-asset ratio measures the percentage of total assets
which are financed through debt. The formula to compute debt-to-asset ratio which is as
follows:
The higher the ratio weaker will be the solvency and higher will be the financial risk. For
instance, the debt-to-asset ratio is .65 then it means that the 65% of total assets are financed
through debt which indicates that the company is not financially healthy.
 Financial Leverage ratio: This ratio is used to measure the effect of usage of debt on
overall profitability. This ratio helps in determining how the company is using borrowed
capital to increase its profitability or to reduce its cost of capital. This can be calculated
as follows:
Interest Coverage Ratio: Interest coverage ratio determines how many times the
company may cover its interest through its earnings before interest and taxes. This ratio
can be computed by using following formula:
The higher ratio indicates the strong solvency along with lower financial risk.
Advantages and Limitations of Solvency analysis:
Solvency analysis helps to evaluate the company’s solvency along with its financial health. The
following are the advantages of solvency analysis:

Solvency analysis allows you to perform various tasks such as forecasting the company’s
financial position and its stability, supervise the company’s ability to repay its obligations
and evaluate the effectiveness of using its funds.
Solvency helps the company to check its survival capacity.
 Solvency analysis helps the company to procure funds from outside sources as strong
solvency will help them to procure funds more easily.
 Investor also analyzes the company’s solvency and liquidity so that they can take
rational investment decisions.
The solvency analysis is generally done through solvency ratios which is not a sufficient
measure. There are other factors such as cash management practices conducted in an
organization also affects the company’s solvency. For instance, a company uses less debt as
compared to equity but its cash management practices are ineffective then it can be concluded
that the company is highly solvent.
Key Takeaways:
 Solvency analysis is the process whereby the company’s ability to meet its long-term
obligations is analyzed.
 Solvency ratios such as debt-to-equity ratio, debt-to-asset ratio, financial leverage ratio,
debt-to-capital ratio and interest coverage ratio are used for performing solvency
analysis for an organization.
 The solvency analysis helps the investors to take various investment or disinvestment
decisions.
 To perform solvency analysis alone is not enough to analyze the company’s ability to
meet its long-term and short-term debt.
Word count: 903
Lexile: 1210L to 1400L
Number of images: 2

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Solvency Analysis

Example of Solvency Analysis:

Net income $60,000

Ways to do Solvency Analysis:

 Debt-to-Capital Ratio: Debt-to-capital ratio measures the percentage of debt to the

Advantages and Limitations of Solvency analysis:

Word count: 903

Lexile: 1210L to 1400L

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