Solvency Ratio

The Solvency ratio is a way investors can measure the company’s ability to meet its long term obligations. Obviously if the company is going to go bankrupt you do not want to invest in it.

To make sure that the company will be able to prosper even with its long term debt obligations we can use this formula.

Solvency Ratio = (After Tax Profits + Depreciation)/ (long term liabilities + Short term liabilities

The higher the ratio is the better equipped a company is to pay off its debts and survive in the long term. In general a ratio of 20% or higher is considered to be a good ratio where as a ratio of 20% or lower is considered to be a bad ratio.

As most ratios this should be compared with other companies in the same industry group. Some groups like airlines will have much higher debt then others such as internet companies. That should be taken into consideration.

It may also be a good idea to compare it with other financial indicators which can also give you an indication of how well off a company is financially.

Other Financial Ratios

Here are a few other financial ratios which can give you some more insight of the strength of a given company.

Levered Free Cash Flow – Tells an investor how much cash flow a company has after it pays off its debts.

Gordon Growth Model - This ratio looks at the growth of the dividends in the future.

Cash Current Debt Coverage – This ratio measures a company’s ability to pay off its current debts. (Debts due within 1 year)