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Solvency Ratios

Solvency (liquidity)

  • Provides a lenders perspective
  • Is the company able to meet its financial obligations on time?
  • How much is on hand that can be converted to cash to pay the bills?
  • Important figures for credit managers of commercial companies and financial institutions

Current Ratio = Current assets/Current liabilities

-This ratio measures the degree to which current assets cover current liabilities, and is a measure of the financial liquidity, or cash generating ability, of a firm.

-Higher ratio, more assurance exists that the retirement of current liabilities can be made.

-Lower ratio, a company may have difficulty meeting its obligations that are payable over the next year with the assets that it can turn into cash over the next year.

-A ratio >1 shows liquidity

-A ratio of 2 or more generally means a strong financial condition

 

Quick Ratio = (Current assets – Inventories)/Current liabilities

-More conservative 

-This ratio answers “Can this firm meet its current obligations from its liquid assets if suddenly all sales stop?”

-It excludes inventories (least liquid asset) to concentrate on the more liquid assets of the firm.

-1.0 or higher is considered satisfactory by lenders and investors

-Below 0.5 an investor should be wary

Current Liabilities to Net Worth (%) = Current liabilities/Net Worth x 100

Note: Net Worth = Total assets – Total liabilities

-This ratio indicates the amount due to creditors within a year as a percentage of owners’ (or stockholder’s) capital.  

-In another words, it contrasts the funds that creditors temporally are risking with the funds permanently invested by the owners.

-The smaller the net worth and the larger the liabilities, the less security for the creditors.

-Should not exceed over 60%

-High percentages means significant pressure on future cash flows

-Low percentages are good

Total liabilities to Net Worth (%) = Total liabilities/Net Worth x 100 

Note: Net Worth = Total assets – Total liabilities

-This ratio helps to clarify the impact of long-term debt, which can be seen by comparing this ratio with Current liabilities to Net Worth

-The difference will pinpoint the relative size of long-term debt, which, if sizable, can burden a firm with substantial interest charges.

-Higher than 100% is not good

-Below 100% is good

 Current liabilities to Inventories = Current liabilities/Inventories

-Indicates reliance on the available inventory for payment of debt.

-This ratio will vary by industry and are only meaningful when compared to others within the same industry

Fixed assets to Net Worth  = Fixed assets/Net Worth

-Indicates the extent to which the owners’ cash is frozen in the form of brick and mortar and machinery, and the extent to which funds are available for the firm’s operations.

-Higher than 0.75% means over-investment and the firm is vulnerable to unexpected events.

-Lower than 0.75% is good

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