Solvency ratios are one of the several tools used to measure the ability of a business to meet its long-term financial obligations. Essentially, this process calls for determining the total income generated by a business, exempting any taxes owed and any type of non-cash depreciation expenses. This figure is then compared to the total amount of long-term debt obligations that the company currently holds. Investors and lenders often look closely at the solvency ratio as a means of evaluating the credit rating of a business and assessing the degree of default risk that is currently present.
There is some difference of opinion on what constitutes an acceptable or good solvency ratio. This is because profit margins will vary from one industry to another. A profit margin that is considered excellent in one industry may be considered very poor in another. Since the net income derived from sales is a major factor in determining the ratio, it is necessary to adjust the evaluation of the outcome to conform with the standards that apply to a given industry.
On average, a solvency ratio that is more than 20% is considered a strong sign that a business is financially healthy and very likely to honor all long-term debt obligations. Should the ratio fall below that percentage, that is an indication that there is some additional risk of either slow payments or total default on a portion of those debts. As the solvency ratio sinks lower over time, this is an indication that the company is undergoing some type of financial distress and is not considered a good credit risk.
While calculating a solvency ratio is one important step in evaluating the potential for default and possibly bankruptcy at some future point, relying solely on this ratio is not generally recommended. When and as possible, lenders and investors should look closely at the income statement and other financial records of the business. Reviewing past performance in terms of meeting obligations is also a key factor. Depending on the industry type and the specific products that are produced by the business, the need to project future trends in regard to the demand for those products is also crucial. While the product line may be selling briskly today and earning a significant profit, a projected shift in technology within that industry could render some of those products obsolete, seriously affecting the ability of the business to honor its short-term and long-term debts.