You have a lot of responsibility as a small business owner, whether you’re managing numerous people or are a self-employed army of one. You have to worry about expenses, numerous financial statements, tax season and more, all while trying to build your net worth. One of the biggest obligations that looms over the head of nearly every business owner is the thought of debt.
Debt can greatly impact the growth capacity of a business, and even worse, it can cause a business to go under completely. Fortunately, there’s a great tool that can help you determine how much debt you can handle and help you understand your company’s general financial health. That tool? The solvency ratio.
What is the solvency ratio?
A key part of a financial analysis, a company’s solvency ratio determines whether it has sufficient cash flow to manage its debts as they come due. The following formula is used to track a business’s solvency ratio, which is usually expressed as a percentage:
(Net income after tax + non-cash expenses) ÷ all liabilities = solvency ratio
Overall, companies with higher solvency ratios are viewed as more likely to meet their financial obligations, whereas those with lower scores are seen as posing a greater risk to banks and creditors. Although a good solvency ratio varies based on the industry in question, a company with a ratio of 0.5 is generally considered healthy.
Solvency ratios are sometimes referred to as “leverage ratios,” but it’s important to realize that solvency ratios aren’t the same as liquidity ratios. While liquidity ratios refer to the capacity of a company to handle short-term liabilities, solvency measures the ability to pay long-term debts.
In the long run, keeping an eye on your solvency ratio can prevent your company from going bankrupt because of rising debt levels. In other words, knowing your ratio should help you determine when you can and can’t handle additional debt.
The importance of calculating solvency
Periodically checking your business’s solvency ratios can help ensure your company’s fiscal health. In addition to helping businesses evaluate their capital structures, solvency ratios may assist owners in determining whether internal and external equities must be redistributed. Furthermore, solvency ratios may affect your decision to take on more debt down the line. Businesses with excessive debt may struggle to manage cash flow or deal with rising interest levels.
Not only does calculating solvency help companies make important financial decisions and ensure future profitability, but it also reassures creditors and shareholders that your business can pay its debts.
Lenders want to know that your company can pay back the loan principal, as well as the interest that accumulates. A poor solvency ratio may suggest your company will be unable to meet its obligations in the long term.
A good solvency ratio varies by industry, so it’s important to compare your numbers with those of your competitors. Because businesses in some industries are able to survive with solvency ratios that would be considered unhealthy in others, companies should refrain from scrutinizing these numbers in a vacuum. Historically, technology companies tend to boast higher solvency ratios than those in debt-heavy industries like utilities.
Types of solvency ratios
There are different types of solvency ratios you can use to track different elements of your finances. Here are some of the most common types of solvency ratios companies track on a regular basis.
Debt-to-equity
This ratio is a measure of total debt, as compared to shareholder equity. As an equation, you take your business’s total liabilities and divide them by your shareholders’ equity.
In general, a high solvency ratio tends to indicate that a company is fiscally sound, while a high debt-to-equity ratio suggests that the company over-utilized debt to bankroll its growth. As interest levels continue to climb, companies may suffer from volatile earnings. To prevent insolvency, business owners need to focus on deferring costs, reducing debt and boosting overall profits.
Total-debt-to-total-assets
This refers to the ratio of long-term and short-term liabilities compared to total holdings. As an equation, it’s expressed as your business’s short- and long-term liabilities divided by its total assets. As a company’s total-debt-to-total-assets ratio increases, it poses a greater financial risk to banks and creditors.
When calculating total-debt-to-total-assets, it’s important to take into account the degree of leverage. Financial leverage generally refers to a borrowed amount that gives more purchasing power, such as taking out a loan to buy new equipment or further invest in your company.
While some liabilities, such as supplier costs and employee bonuses, may be negotiable, companies with high total-debt-to-total-assets have higher leverages and, as a result, lower flexibility. In short, these businesses are reaching a point where they owe more than they could be worth. Because of this, businesses should strive to raise the value of current assets or reduce their debt levels moving forward.
Interest-coverage ratios
These ratios measure a company’s ability to keep up with interest payments, which rise along with outstanding debt. As a business owner, you can calculate interest-coverage ratio by dividing earnings before interest and tax (EBIT) by interest expenses.
Typically, a company with an interest-coverage ratio of 1.5 or less is viewed as financially unstable and may struggle to secure loans from banks and other lenders. To boost your interest-coverage ratio, strive to reduce debt and boost overall profits.
Improving your solvency
You might be wondering whether you’re doomed if you determine you have a poor solvency ratio. Fortunately, most companies can take steps to improve their solvency ratios and boost profitability in the long term. A great way of doing this is by improving your debt-to-total-asset ratio. The following can help you work toward this.
- Have a sales push: This might seem like a “Duh” moment, but it’s worth stressing. If your numbers aren’t where you want them or your ratio is out of whack, have a sales campaign and try boosting your sales. Even a temporary boost can help offset any debt and make your ratio more appealing to investors. If you’re looking for investors at a certain point, really push for sales ahead of time to show what your company is capable of and to boost solvency.
- Issue stock: This may not be applicable if your company isn’t traded, but if it is, you can issue new stocks to boost your cash flow. This money can be used for short-term obligations and debt, and can help boost your solvency and get you out of any immediate high-risk debt. This can, in turn, help you focus on long-term obligations as well, as you’ll have freed up income with that prior debt out of the way.If you do decide to go this route, make sure you don’t fall prey to share dilution. This is when you issue too many stocks and devalue the stocks your current holders have. There’s a fine balance to maintain, so speak with a financial advisor first.
- Avoid new debt: Again, this may seem like it goes without saying, but avoid taking on any new debt while you try to improve your solvency ratio.
- Reevaluate operating expenses: It’s easy to incur operating expenses and let them continue to accrue without checking them. Go over your current operating expenses and see if there are places you can cut back. It’s possible you’re using certain vendors who are now overpriced, so make sure you evaluate services you need to see if you can get a better price. This can not only help your debt-to-income ratio, but also increase your operating income.
- Look for bulk discounts: If you’ve been with your vendors for a while, try reaching out and seeing if you can get a bulk discount. Oftentimes, vendors will be happy to keep their current customers by giving bulk discounts. Just like the previous step, this can help increase your operating income and reduce your expenses.
- Increase owner equity: This can be easier said than done, depending on your personal finances. If you have the money to spare, try buying into your company more and increasing the amount of owner’s equity. This can help offset any debt obligations and sway the ratio in your favor, again making your company more solvent.
As always, speak with a financial consultant or advisor before making any decisions involving funds.
Staying solid with solvency
Solvency ratios don’t just affect your ability to get loans from banks and creditors, but also forecast your company’s health in the coming years. By calculating your business’s ratios often, you can ensure you have the most accurate and thorough understanding of your finances, which will keep you from becoming insolvent.
Hammering out tons of equations is often at the bottom of the “fun list” for business owners, but it can pay off in the long run by helping you course correct and land investors. Who knows, maybe you’ll end up enjoying all the number crunching and accounting. And, if not, at least your business will be solid—just like you.
This article was produced by the QuickBooks Resource Center and syndicated by MediaFeed.org.
Featured Image Credit: torwai / iStock.
