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:

37.1 Debt to asset ratio

When there is more debt than assets, that means the company is owned by creditors and not by it's owners.

37.1.1 How to use debt to asset ratio

37.1.2 Why do investors use the debt to asset ratio in their analysis

 It shows how much debt the company used to finance its assets. 

37.1.3 Things to be aware of

37.1.4 How to calculate debt to asset ratio

37.1.5 Real life example

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. 

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. A ratio above 1 means the company is funded by credit and took on many loans.

37.2 Debt to equity ratio

Shareholders equity = total assets - total liabilities. What's leftover after all liabilities (debt) are paid off is called shareholders equity.

37.2.1 How to use debt to equity ratio

37.2.2 Why do investors use the debt to equity ratio in their analysis

It shows how much debt the company used to finance their operations. 

37.2.3 Things to be aware of

37.2.4 How to calculate debt to equity ratio

Debt to equity ratio = total debt / shareholders equity

37.2.5 Real life example

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:

You can find the shareholders' equity in the balance sheet. 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.

Not all debt is equally risky. Meaning you can adjust the ratio by including or excluding certain amounts of debt. Short term debts are less risky because they have to be paid back within one year anyway. It’s much easier to plan one year ahead versus five or ten years.

37.3 Conclusion

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

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.

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