How to determine the solvency of a company?

Solvency is the ability of a company to meet it’s long term financial obligations. The company is considered solvent  when the current assets exceed the current liabilities. To calculate the solvency there are a few ratios to consider:

• Total debts to total assets ratio
• Debt to equity ratio

Total debts to total assets ratio

The debt to total assets ratio shows if the company is owned by creditors or shareholders. Or in other words, the total debt in relation to the total amount of assets. It shows how much debt the company used to finance its assets. To calculate:

• Total debts to total assets ratio = total debt / total assets

If the ratio is 0,6, that means that 60% is financed by creditors and 40% is financed by its owners (shareholders). In this case, a higher ratio means more risk because most of the company is financed by creditors.

Debt to equity ratio

Debt to equity measures the total debt versus the total shareholders equity. While the total debts to total assets ratio uses total assets, the debt to equity ratio looks at the total equity of shareholders. Where equity of shareholders are:

• Common shares
• Preferred shares
• Retained earnings (net profits after dividend payments)

You can find the shareholders' equity in the balance sheet. Debt to equity is calculated as follows:

• Debt to equity ratio = total debt / shareholders equity

A ratio between 0,5 and 1,5 is preferred. If the ratio is above 1.5,  that would indicate creditors have significantly more stake (debt) in the company than the shareholders. In other words, the company is using a lot of debt to finance their operations.

Now you can make more profitable investing decisions by determining the financial health of a company. We looked at:

• Profitability
• Operating Efficiency
• Liquidity
• Solvency

All have a crucial part in determining how healthy a company is. But it does not always tell the whole picture. You should always compare ratios between the same kind of companies and industries. Also, ratios may vary widely between industries. Some companies just need way more debt to operate. The above ratios should always be evaluated over time. If one or more ratios are out of line when comparing to companies in the same industry, this might be a red flag. In my tool, all of the above mentioned ratios are already calculated for every company around the world (if the data is available). There is also a notification if the result is considered good or bad. This helps you focus on the important things.

Key Concepts:

• Solvency is the ability of a company to meet it’s long term financial obligations.
• The debt to total assets ratio shows if the company is owned by creditors or shareholders. Or in other words, the total debt in relation to the total amount of assets.
• Debt to equity measures the total debt versus the total shareholders equity.
• Finding out if a company is healthy or not is done by looking at multiple parts:
  • Profitability
  • Operating Efficiency
  • Liquidity
  • Solvency

Chapters: The Ultimate Investing Guide