Solvency and Its Ratios

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Solvency
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What is 'Solvency'
Solvency is the ability of a company to meet its long-term financial
obligations. Solvency is essential to staying in business as it asserts a
companys ability to continue operations into the foreseeable future. While a
company also needs liquidity to thrive, liquidity should not be confused with
solvency. A company that is insolvent must often enter bankruptcy
bankruptcy..

BREAKING DOWN 'Solvency'
Solvency directly relates to the ability of an individual or business to pay
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their long-term debts including any associated interest. To be considered
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solvent, the value of an entitys assets, whether in reference to a company or
an individual, must be greater than the sum of its debt obligations. Various
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mathematical calculations can be performed to help determine the solvency
of a business or individual.
Solvency Ratios
Investors can use ratios to analyze a company's solvency. The interest coverage ratio divides
operating income by interest expense to show a company's ability to pay the interest on its debt,
with a higher result indicating a greater solvency.
solvency. The debt-to-assets ratio divides a company's debt
by the value of its assets to show whether a company has taken on too much debt, with a lower
result indicating a greater solvency. Equity ratios demonstrate the amount of funds that remain after
the value of the assets, offset by the outstanding debt, is divided among eligible investors.
Solvency ratios vary by industry, so it is important to understand what constitutes a good ratio for
the company before drawing conclusions from the ratio calculations. Ratios that suggest a lower
solvency than the industry average may suggest financial problems are on the horizon.
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Risks to Solvency
Certain events can create a risk to an entitys solvency. In the case of business, the pending
expiration of a patent may pose risks to solvency as it will allow competitors to produce the product
in question, and it results in a loss of associated royalty payments. Further, changes in certain
regulations that directly impact a companys ability to continue business operations can pose an
additional risk. Both businesses and individuals may experience solvency issues should a large
judgement be ordered against them after a lawsuit.
Solvency Vs. Liquidity

While solvency represents a companys ability to meet long-term obligations, liquidity represents a
company's ability to meet its short-term obligations. In order for funds to be considered liquid, they
must be either immediately accessible or easily converted into usable funds. Cash is considered the
most liquid payment vehicle. A company that lacks liquidity can be forced to enter bankruptcy even
if it is solvent if it cannot convert its assets into funds that can be used to meet financial obligations.
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Solvency Ratio
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A key metric used to measure an enterprises ability to meet its debt and other obligations. The
solvency ratio indicates whether a companys cash flow is sufficient to meet its short-term and long-
term liabilities.
liabilities. The lower a company's solvency ratio, the greater the probability that it will default
on its debt obligations.
The measure is usually calculated as follows:
BREAKING DOWN 'Solvency Ratio'
Solvency ratio, with regard to an insurance company, means the size of its capital relative to the
premiums written, and measures the risk an insurer faces of claims it cannot cover.
The solvency ratio is only one of the metrics used to determine whether a company can stay solvent.
Other solvency ratios include debt to equity, total debt to total assets,
assets, and interest coverage ratios.
ratios.
However, the solvency ratio is a comprehensive measure of solvency, as it measures cash flow
rather than net income by including depreciation to assess a companys capacity to stay afloat. It
measures this cash flow capacity in relation to all liabilities, rather than only debt. Apart from debt
and borrowings, other liabilities include short-term ones such as accounts payable and long-term
ones such as capital lease and pension plan obligations.
Measuring cash flow rather than net income is a better determinant of solvency, especially for
companies that incur large amounts of depreciation for their assets but have low levels of actual
profitability. Similarly, assessing a companys ability to meet all its obligations rather than debt
alone provides a more accurate picture of solvency. A company may have a low debt amount, but
if its cash management practices are poor and accounts payable is surging as a result, its solvency
position may not be as solid as would be indicated by measures that include only debt.
A companys solvency ratio should also be compared with its competitors in the same industry
rather than viewed in isolation. For example, companies in debt-heavy industries like utilities and
pipelines may have lower solvency ratios than those in sectors such as technology. To make an
apples-to-apples comparison, the solvency ratio should be compared for all utility companies, for
example, to get a true picture of relative solvency.
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Solvency Capital
Requirement
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A solvency capital requirement is the amount of funds that insurance and reinsurance undertakings
are required to hold in the European Union. Solvency capital requirement is a formula-based figure
calibrated to ensure that all quantifiable risks are taken into account, including non-life
underwriting,, life underwriting, health underwriting, market, credit, operational and counterparty
underwriting
risks. The solvency capital requirement covers existing business as well as new business expected
over the course of 12 months, and is required to be recalculated at least once per year.
BREAKING DOWN 'Solvency Capital Requirement'

Solvency capital requirements are part of the Solvency II Directive issued by the European Union
(EU) in 2009, which replaces 13 existing EU directives. The directive aims to coordinate laws and
regulations of the 27 EU members (including the United Kingdom) as they relate to the insurance
industry. If the supervisory authorities determine that the requirement does not adequately reflect
the risk associated with a particular type insurance, it can adjust the capital requirement higher.
The solvency capital requirement is set at a level to ensure that insurers and reinsurers can meet
their obligations to policy holders and beneficiaries over the following 12 months with a 99.5%
probability, which limits the chance of falling into financial ruin to less than once in 200 cases. The
formula takes a modular approach, meaning that individual exposure to each risk category is
assessed and then aggregated together.
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Liquidity Ratios
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Liquidity ratios measure a company's ability to pay debt obligations and its margin of safety through
the calculation of metrics including the current ratio,
ratio, quick ratio and operating cash flow ratio.
ratio.
Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term
debts in an emergency. Bankruptcy analysts and mortgage originators use liquidity ratios to
evaluate going concern issues, as liquidity measurement ratios indicate cash flow positioning.
BREAKING DOWN 'Liquidity Ratios'

Liquidity ratios are most useful when they are used in comparative form. This analysis may be
performed internally or externally. For example, internal analysis regarding liquidity ratios involves
utilizing multiple accounting periods that are reported using the same accounting methods.
Comparing previous time periods to current operations allows analysts to track changes in the
business. In general, a higher liquidity ratio indicates that a company is more liquid and has better
coverage of outstanding debts.
Alternatively, external analysis involves comparing the liquidity ratios of one company to another
company or entire industry. This information is useful to compare the company's strategic
positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis
may not be as effective when looking across industries, as various businesses require different
financing structures. Liquidity ratio analysis is less effective for comparing businesses of different
sizes in different geographical locations.
Solvency Versus Liquidity

Solvency relates to a company's overall ability to pay debt obligations and continue business
operations, while liquidity focuses more on current financial accounts. A company must have more
total assets than total liabilities to be considered solvent and more current assets than current
liabilities to be considered liquid. Although solvency is not directly correlated to liquidity, liquidity
ratios present a preliminary expectation regarding the solvency of a company.
Examples of Liquidity Ratios

The most basic liquidity ratio or metric is the calculation of working capital. Working capital is the
difference between current assets and current liabilities. If a business has a positive working capital,
this indicates it has more current assets than current liabilities and in the event of an emergency, the
business can pay all of its short-term debts. A negative working capital indicates that a company is
illiquid.
The current ratio divides total current assets by total current liabilities. This ratio provides the most
basic analysis regarding the coverage level of current debts by current assets. The quick ratio
expands on the current ratio by only including cash, marketable securities and accounts receivable
in the numerator. The quick ratio reflects the potential difficulty in selling inventory or prepaid
assets in the result of an emergency.
Keepwell Agreement
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A contract between a parent company and its subsidiary to maintain solvency and financial backing
throughout the term set in the agreement.
BREAKING DOWN 'Keepwell Agreement'

This is a method by which subsidiary companies may increase the creditworthiness of debt
instruments and corporate borrowing.
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Free Asset Ratio - FAR

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A metric used to determine whether an insurance company has sufficient free capital to fully cover
its financial obligations. The free asset ratio (FAR) is calculated by subtracting the required minimum
margin of solvency from available assets and dividing this figure by admissible assets. The higher
the FAR, the better the capacity of the insurer to cover its policy liabilities and other obligations.
BREAKING DOWN 'Free Asset Ratio - FAR'

Free asset ratios furnished by different insurance companies may not always be comparable, as they
may use differing assumptions and interpretations in calculating free assets and valuing liabilities.
Nevertheless, a high FAR would generally indicate a strong financial position and surplus capital,
while a low FAR would imply a weak balance sheet and possibly a need for imminent injection of
capital.
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Current Ratio
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The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-
term obligations. To gauge this ability, the current ratio considers the current total assets of a
company (both liquid and illiquid
illiquid)) relative to that companys current total liabilities
liabilities..
The formula for calculating a companys current ratio, then, is:
Current Ratio = Current Assets / Current Liabilities
The current ratio is called current because, unlike some other liquidity ratios, it incorporates all
current assets and liabilities.
The current ratio is also known as the working capital ratio.
BREAKING DOWN 'Current Ratio'

The current ratio is mainly used to give an idea of the company's ability to pay back its liabilities
(debt and accounts payable)
payable) with its assets (cash
(cash,, marketable securities
securities,, inventory
inventory,, accounts
receivable).
receivable ). As such, current ratio can be used to take a rough measurement of a companys financial
health.. The higher the current ratio, the more capable the company is of paying its obligations
health obligations,, as it
has a larger proportion of asset value relative to the value of its liabilities.
A ratio under 1 indicates that a companys liabilities are greater than its assets and suggests that the
company in question would be unable to pay off its obligations if they came due at that point. While
a current ratio below 1 shows that the company is not in good financial health, it does not
necessarily mean that it will go bankrupt
bankrupt.. There are many ways for a company to access financing,
and this is particularly so if a company has realistic expectations of future earnings against which it
might borrow. For example, if a company has a reasonable amount of short-term debt but is
expecting substantial returns from a project or other investment not too long after its debts are due,
it will likely be able to stave off its debt. All the same, a current ratio below 1 is usually not a good
sign.
On the other hand, a high ratio (over 3) does not necessarily indicate that a company is in a state of
financial well-being either. Depending on how the companys assets are allocated,
allocated, a high current
ratio may suggest that that company is not using its current assets efficiently, is not securing
financing well or is not managing its working capital well. To better assess whether or not these
issues are present, a liquidity ratio more specific than the current ratio is needed.
An example: assume that Big-Sale Stores has $2 billion in cash, $1 billion in securities, $4 billion in
inventory, $2 billion in accounts receivable and $6 billion in liabilities. To calculate Big-Sales current
ratio, you would take the sum of its various assets and divide them by its liabilities, for a current
ratio of 1.5 (($2B + $1B + $4B + $2B) / $6B = $9B / $6B = 1.5). Big-Sale Stores, then, appears to have
healthy financials.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to
turn its product into cash. Companies that have trouble getting paid on their receivables or have
long inventory turnover can run into liquidity problems because they are unable to alleviate their
obligations.
Limitations of 'Current Ratio'

No oneratio is a perfect gauge of a companys financial health or of whether or not investing in a
company is a wise decision. As such, when using them it is important to understand their limitations,
and the same holds true for the current ratio.
One limitation of using the current ratio emerges when using the ratio to compare different
companies with one another. Because business operations can differ substantially between
industries, comparing the current ratios of companies in different industries with one another will
not necessarily lead to any productive insight. For example, while in one industry it may be common
practice to take on a large amount of debt through leverage
leverage,, another industry may strive to keep
debts to a minimum and pay them off as soon as possible. Companies within these two industries,
then, could potentially have very different current ratios, though this would not necessarily indicate
that one is healthier than the other because of their differing business practices. As such, it is always
more useful to compare companies within the same industry.
Another drawback of using current ratios, briefly mentioned above, involves its lack of specificity. Of
all of the different liquidity ratios that exist, the current ratio is one of the least stringent. Unlike
many other liquidity ratios, it incorporates all of a companys current assets, even those that cannot
be easily liquidated. As such, a high current ratio cannot be used to effectively determine if a
company is inefficiently deploying its assets, whereas certain other liquidity ratios can.
'Current Ratio' and Other Liquidity Ratios

Generally, liquidity ratios can be used to gauge a companys ability to pay off its debts. However,
there are a variety of different liquidity ratios that exist and that measure this in different ways.
When considering the current ratio, it is important to understand its relationship to other popular
liquidity ratios.
One popular ratio is the working capital ratio, which is the same as the current ratio.
Another class of liquidity ratios works in a similar way to the current ratio, but are more specific as to
the kinds of assets they incorporate. The cash asset ratio (or cash ratio), for example, compares only
a companys marketable securities and cash to its current liabilities. The acid-test ratio (or quick
ratio)) compares a companys easily liquidated assets (including cash, accounts receivable andSearch
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term investments, excluding inventory and prepaids) to its current liabilities. The operating cash
flow ratio compares a companies active cash flow from operations to its current liabilities. These
liquidity ratios have a more specific purpose than the current ratio, that is,to gauge a companys
ability to pay off short term debts.
Another similar liquidity ratio is the debt ratio,

ratio, which is the opposite of the current ratio. Debt ratio
calculations take current liabilities as the numerator and current assets as the denominator in an
attempt to measure a companys leverage.
Solvency Cone
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A model that considers the impact of transaction costs while trading financial assets. The solvency
cone at a certain time ("t") is the set of those positions that can be exchanged into a non-negative
portfolio at time t after taking bid-ask prices into consideration. The spread between bid and ask
prices is a very significant component of transaction costs.
BREAKING DOWN 'Solvency Cone'

Classical financial models generally do not take transaction costs into account, which hampers their
application in the real world, since these costs are a significant factor in trading decisions. The
solvency cone eliminates this drawback by taking transaction costs into account in its model. The
concept finds a great deal of application in markets such as foreign exchange. While bid-ask spreads
can be quite narrow in the foreign exchange market, the large position sizes in the interbank and
institutional segments of the forex market can result in significant transaction costs.
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Asset Coverage Ratio

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The asset coverage ratio is a test that determines a company's ability to cover debt obligations with
its assets after all liabilities have been satisfied. When calculating the asset coverage ratio, investors
should exercise caution with respect to asset value; using the coverage ratio of the actual liquidation
value of assets is significantly less. As a rule of thumb,
thumb, utilities should have an asset coverage ratio of
at least 1.5, and industrial companies should have an asset coverage ratio of at least 2.
BREAKING DOWN 'Asset Coverage Ratio'

Companies have two primary ways to raise capital: through debt and through equity. Equity does
not need to be paid back if earnings fall, but debt must be paid back no matter what. As a result,
banks and investors holding debt want to know that company's earnings are sufficient to cover
future debt obligations, but they also want to know what happens if earnings falter. One option, just
as it is for the average person, is to start selling assets. The asset coverage ratio tells bankers and
investors how many times the company's assets can cover its debts.
Asset Coverage Ratio Usage

If a company wants a loan, it goes to its banker first. The banker then analyzes the company's
balance sheet to see if it can afford the loan. In particular, and especially if the company has a poor
credit rating,
rating, the bank is likely to require the company to provide collateral in the form of assets that
can be sold if the company defaults on the loan.
One popular financial solvency ratio is the asset coverage ratio. It measures how well a company can
cover its short-term debt obligations with assets. A company that can cover its debts with assets
which is to say, the company that has more assets than it does short-term debt, is the better
company. The more times it can cover this debt, the better. So, a company with a high asset
coverage ratio is considered to be less risky than a company with a low asset coverage ratio, even if it
has poor credit history and/or a history of default
default..
Asset Coverage Ratio Calculation

The asset coverage ratio is calculated with the following equation:
((Assets Intangible Assets) (Current Liabilities Short-term Debt)) / Total Debt
In this equation, "assets" refers to total assets, and "intangible assets" are assets that can't be
physically touched, such as goodwill or patents. "Current liabilities" are liabilities and debts due
within one year, and "short-term debt" is debt that is also due within one year. "Total debt" includes
both short-term and long-term debt.
debt. All of these line items can be found in the annual report.
report.
There is one caveat to consider when interpreting this ratio. Assets found on the balance sheet are
held at their book value,
value, which is often higher than the liquidation or selling value. The coverage
ratio may be slightly inflated. This concern can be partially eliminated by comparing the ratio
against other companies in the same industry.

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Solvency and Its Ratios

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Solvency Vs. Liquidity

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The measure is usually calculated as follows:

BREAKING DOWN 'Solvency Ratio'

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BREAKING DOWN 'Solvency Capital Requirement'

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BREAKING DOWN 'Liquidity Ratios'

Solvency Versus Liquidity

Examples of Liquidity Ratios

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BREAKING DOWN 'Keepwell Agreement'

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Free Asset Ratio - FAR

BREAKING DOWN 'Free Asset Ratio - FAR'

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The formula for calculating a companys current ratio, then, is:

Current Ratio = Current Assets / Current Liabilities

The current ratio is also known as the working capital ratio.

BREAKING DOWN 'Current Ratio'

Limitations of 'Current Ratio'

'Current Ratio' and Other Liquidity Ratios

Another similar liquidity ratio is the debt ratio,

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BREAKING DOWN 'Solvency Cone'

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Asset Coverage Ratio

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BREAKING DOWN 'Asset Coverage Ratio'

Asset Coverage Ratio Usage

Asset Coverage Ratio Calculation

((Assets Intangible Assets) (Current Liabilities Short-term Debt)) / Total Debt

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