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What are Solvency Ratios and What do They Measure?

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Question: What are Solvency Ratios and What do They Measure?
Answer:

Solvency ratios measure the ability of a company to pay its long term debt and the interest on that debt. Solvency ratios, as a part of financial ratio analysis, help the business owner determine the chances of the firm's long-term survival.

What are Solvency Ratios?

Solvency ratios are of interest to long-term creditors and shareholders. These groups are interested in the long-term health and survival of business firms. In other words, solvency ratios have to prove that business firms can service their debt or pay the interest on their debt as well as pay the principal when the debt matures.

Solvency Ratio Calculation and Interpretation

One ratio in particular serves as both a debt ratio and a solvency ratio. That ratio is the Total Debt/Total Assets ratio. This ratio measures how much of the firm's asset base is financed using debt. Let's say that the Total Debt/Total Assets ratio = 50%. This means that half the firm's assets are financed using debt and the other half are financed using equity sources.

The only way you know if this is high or low or average is if you have industry average data to compare to. If industry average data for this firm's industry is around 50%, then you know your firm is in line with the industry and you are probably doing well with regard to the Debt/Assets ratio. If the Debt/Assets ratio for your company is, for example, 65%, then your debt is high as compared to other firms in your industry and you should definitely take a look at it. Your company is not as solvent as other firms in the industry.

Solvency ratios help the business owner keep an eye on possible bankruptcy. As the Debt/Asset ratio increases, the likelihood of bankruptcy also increases as the firm is financed more and more with debt as opposed to equity sources.

Solvency vs Liquidity

I have seen some college textxbooks and books for small business owners that lump solvency in with liquidity, even calling them the same thing. Solvency and liquidity are not the same thing. Liquidity is a measure of the firm's ability to pay short-term debt. Solvency is a measure of the firm's ability to pay all debt, particularly long-term debt and is a measure of the firm's long-term survival.

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