Solvency ratio is financial ratio that measures the ability of a company to meet its long term debt. The solvency ratio shows if a company cash flow is sufficient to cover its short term and long term liabilities. The higher the solvency ratio the better the company financial health is. Unlike other liquidity ratios, the solvency ratio is focusing more on the long term sustainability of a company. Solvency is the ability of a company to continue its operations for long period of time and be able to cover its debt obligations. The main difference between solvency and liquidity is that the liquidity ratios usually only focus on the short term liabilities, where solvency ratio is focusing on the long term liabilities and debt obligations.
The formula for calculating solvency ratio of a company is:
Solvency ratio = (After Tax Net Profit + Depreciation) / Total liabilities
Acceptable solvency ratios may vary from industry to industry. As a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound. Solvency ratios are calculated for measuring the financial position to determinate whether the business is financially healthy to meet its long-term commitments. Generally, a lower solvency ratio of a company reflects a higher probability of the company being on default with its debt obligations.