If you’re an investor, you need to know what a solvency ratio is. There are tons of different terms, definitions, and other pieces of information investors need to know. Fact is, there is a massive wealth of knowledge in the investing field and at times it can be overwhelming. Even if you find yourself intimidated when you start trading, don’t worry. As with anything else, investing is about time, patience, and effort. So long as you keep working at it, you’ll eventually acquire the information you need in order to be a top notch investor.
Solvency Ratio Explained
So what is a solvency ratio? It is an essential metric that is used to examine an enterprise or company’s ability to meet its obligations, including debt. Solvency basically determines that the company’s current cash situation is able to meet its short and long term liabilities. This probably sounds confusing, but in practice it’s pretty simple.
Solvency Ratio in Banks
Let’s take the example of banks. Think about how a bank works. You go and deposit your money. The bank then uses it to lend out money to businesses, people buying homes and cars, and for other things. On one hand your money is protected, it’s your money. At the same time, it’s not like the bank has a safe where they hold “your money.” So how can you be sure that banks will have money when you go to withdraw your money? If the bank is solvent, they will be able to give you your money. If the bank was insolvent, it’d be unable to do so.
Often, you’ll hear about governments performing stress tests. These stress tests look at the banks’ solvency, among other things. Solvency is very important for financial systems, and if banks or other major institutions become insolvent, the entire system can collapse. The same is true for businesses and other organizations. Cash flow is very important. Keep in mind, it’s not as simple of a matter as profits and losses, sales numbers, or anything else. Solvency and cash liquidity is a bit more complex.
For example, a company may have sold a lot of products, but it may have done so on credit. In theory, the company could have a lot of money, at least in the form of owed debts. In reality, if the company is unable to afford its immediate costs, such as wages for staff, it could end up collapsing because it is insolvent.
Computing for Solvency Ratio
Solvency can be determined through many ways, but the most common solvency ratio goes like this:
Solvency ratio formula = After Tax profit (or net income) + Depreciation divided by short-term liabilities + long-term liabilities
Basically, the solvency ratio looks at how much money a company has on hand and compares it to its liabilities. This ratio is very useful for investors because it helps them identify one of the biggest risks any company can face (namely, that they suffer a cash squeeze and become insolvent.) One interesting thing about the ratio is that it’s a long term solvency ratio that looks not just at short term liabilities, but also long-term ones.
What the Solvency Ratio Cannot Tell You
Besides solvency ratios, there are numerous other ways to examine solvency. Further, just because a company has a good solvency ratio, that doesn’t tell you everything you need to know. For example, the company might be sitting on plenty of cash, but could be bleeding out money because its products aren’t selling. Or the company could be suffering a bit of a cash crunch because it is a newer startup, or has been investing in research, but that doesn’t mean that the company is a bad investment. Solvency ratio analysis is very useful, but it is one of many tools that you can and should use.
Solvency Ratio List
If you want to learn more about companies and their solvency ratios, you can find a solvency ratios list. This list will allow you to quickly and easily compare solvency. Keep in mind, however, that many lists may be out of date unless they are frequently updated. The situation for companies and their solvency can change very quickly, so make sure you keep a close eye on developments and only use the most recent data if you’re calculating the ratio on your own.
Companies that have a lot of cash on hand are often attractive investments not just because they are solvent. Cash also allows companies to be more responsive to changing conditions and to invest in themselves. By looking at solvency ratios you can get a good idea of how much flexibility a company has. These ratios, along with numerous other indicators, can be used in a lot of different ways. When formulating your investment strategies, consider all of the different ways you can use the knowledge you have at hand.