Creditworthy companies prosper and grow faster than companies that have difficulty meeting their financial obligations. They also attract more investors and raise capital more easily.
But how do you calculate a company's solvency? The answer is quite simple: with the help of corporate solvency ratios.
How to calculate a company's solvency ratio
There are a number of solvency ratios. Today, we will focus on two of them: the debt ratio and the debt-to-equity ratio.
The debt ratio
The debt ratio refers to the percentage of a company's assets that has been financed by creditors - banks, private lenders, etc.
This ratio is frequently used by financial institutions to determine how your company's assets - inventory, vehicles, equipment, land and buildings - are financed.
The lower your debt ratio, the more banks will favourably assess your ability to repay your debts or take out new loans.
Conversely, a high debt ratio will indicate to them that your business is highly dependent on debt capital, which could signal that your business is financially unsound.
Calculate the debt ratio
Companies that offer accounting and tax services can calculate your debt ratio. But you can also do it yourself.
You can do this by dividing your liabilities by your assets (liabilities/assets).
Your business will be considered solvent if your debt ratio is equal to or greater than 1.
The debt-to-equity ratio
The debt-to-equity ratio is another way of determining a company's solvency.
This indicator shows how much debt a company has in relation to the amount invested by its owners.
This solvency ratio, used by accounting services and banks, among others, indicates the number of dollars borrowed for each dollar of available equity.
Equity represents all the financial resources of the company considered as assets that can be used as collateral once the creditors have been repaid.
In short, the debt-to-equity ratio is a measure of a company's ability to repay its debts.
Generally speaking, banks compare this ratio to industry standards and then use it to assess the risk your company represents.
Calculate the debt-to-equity ratio
To calculate this corporate solvency ratio, you must divide your liabilities by your equity (liabilities/equity).
The higher the ratio, the more your company will be considered a risk.
If you obtain a ratio greater than 1, your assets are mainly financed by debt. If it is less than 1, your equity provides most of the financing.
A company's solvency ratio: an indicator of development potential
Calculating a company's solvency ratio is crucial for determining your company's financial health. Moreover, the solvency ratio makes it possible to track the development of your company over the years. It is also useful for investors considering investing in your company.
So get out your calculator and your financial statements and figure out your company's solvency ratio today.