Solvency Ratio: A crucial measure of your business's financial health

Running a business means keeping an eye on several key financial indicators, and the solvency ratio is one of the big ones. This metric tells you how well your business can handle its long-term debt obligations. 

Want to know how to calculate it and what to do if things don’t look great? Let’s break it all down.

What is solvency, anyway?

At its core, solvency is your business’s ability to repay long-term debts. It’s all about your assets: if what you own and are owed outweighs what you owe, you’re in good shape. A strong solvency position puts banks, investors, and business partners at ease.

For a solvent business, financing is easier to secure, credit terms are friendlier, and growth feels a lot more sustainable. On the flip side, poor solvency can limit your options and even threaten your business’s survival.

Solvency vs. liquidity: What's the difference?

People often confuse solvency with liquidity, but they’re not the same thing.

• Liquidity is about short-term debt (under a year). It’s your ability to quickly cover immediate obligations.
• Solvency is about long-term debt (over a year). It reflects your financial stability over the long haul.

Here’s the catch: a business can be liquid but not solvent—or solvent but not liquid. To stay ahead, you’ve got to monitor both for a full picture of your financial health. Imagine a company that’s great at paying its monthly bills (liquidity) but drowning in long-term loans it can’t repay (poor solvency). That’s the difference.

So, what’s the solvency ratio?

The solvency ratio is your litmus test for long-term financial stability. It’s a percentage that compares your equity to your total debts. The higher the percentage, the better.

• A high ratio means you’ve got plenty of resources to cover your debts, even during tough times.
• A low ratio signals you’re leaning too much on borrowed money, which could spell trouble down the road.

Why should you care about the solvency ratio?

This isn’t just a number on a spreadsheet—it’s a key to making smarter decisions:

1. Build credibility: A strong ratio earns trust from investors and lenders, making it easier to secure funding.
2. Plan for the long Term: Unlike liquidity, the solvency ratio gives you the long-term view of your financial health.
3. Make confident decisions: It helps you know if it’s time to invest or if you should focus on paying down debt.
4. Stay ahead of risks: Regular checks let you spot potential problems early and take action before they escalate.

How to calculate your solvency ratio

The formula is simple:

Solvency Ratio = (Equity / Total Debt) × 100

• Equity includes your share capital, reserves, and retained earnings.
• Total debt covers loans, borrowings, and other financial obligations.

Example: Let’s say you have €200,000 in equity and €100,000 in debt. Your solvency ratio is:
(200,000 / 100,000) × 100 = 200%.

A ratio of 100% or higher is considered healthy. If it’s below 100%, your debts outweigh your equity, which could be a red flag for your financial partners.

Types of solvency ratios you should know

There’s more than one way to measure solvency, and each offers unique insights:

1. Financial Autonomy Ratio: Measures how much of your financing comes from equity.some text
   • Formula: Equity / Total Liabilities
2. Interest Coverage Ratio: Checks if your operating income can cover your interest payments.some text
   • Formula: Operating Income / Interest Expenses
3. Debt Coverage Ratio: Compares available cash flow to total debt.some text
   • Formula: Cash Flow / Total Debt

These ratios work together to give you a 360-degree view of your solvency.

What if your solvency ratio is too low?

If your solvency ratio isn’t where it needs to be, don’t stress. Here are some practical steps you can take:

• Boost equity: Retain more profits, raise capital, or look into a funding round.
• Pay down debt: Tackle loans with the highest interest rates or renegotiate for better terms.
• Increase profitability: Optimize your operations to generate more profit.
• Diversify financing: Explore alternatives like crowdfunding, leasing, factoring, or short-term financing solutions (think Defacto) to reduce reliance on traditional loans.
• Cut costs: Trim non-essential expenses to free up cash and improve margins.

How Defacto can help

Solvency is about playing the long game. When it comes to long-term financing, banks and investors are your go-to partners.

But for short-term cash flow challenges—like covering a payment delay or managing day-to-day operations—that’s where Defacto comes in. Our fast, flexible funding solutions give you the breathing room you need without weighing you down with long-term debt.

Bottom Line: Managing your solvency is crucial for staying in the game long-term. But when you need quick, reliable support for immediate needs, you can count on Defacto to help you keep moving forward!