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The financial growth of a B2B company often depends on external investment. Being able to demonstrate financial stability to investors and banks is therefore essential to sustain and develop its operations.
To determine whether a company can repay all its debts in the short, medium and long term, analysts rely on solvency ratios. As a business, you also need to evaluate whether your customers are financially sound and capable of paying their invoices.
Assessing customer solvency is therefore a key step in reducing customer risk. In this article, we explain what solvency ratios are, how calculating solvency ratios works, and how to interpret the results.
How to assess a company’s solvency and financial stability
To assess the solvency ratio of a company, you first need access to certain financial data. If you are analysing your own business, this information is readily available. However, if you want to assess the solvency of another company (for example a prospective customer) you can start by consulting several sources in the UK:
- Official registers such as Companies House, where annual accounts filed by companies are publicly available
- Legal announcements, particularly those related to legal proceedings, via The Gazette
- Judicial data through County Court Judgements (CCJ), which indicate whether a company has been legally ordered to pay outstanding debts, the amounts involved and whether they have been settled
- Credit reference agencies such as Experian Business, Creditsafe or Dun & Bradstreet, which provide solvency and credit reports
- Advanced financial databases that enrich public data for deeper financial analysis, such as the Orbis database of Moody’s.
- The Office for National Statistics (ONS), which provides macroeconomic and sector-level data useful for analysing markets and industries
But why go further and start calculating solvency ratios?
There are three main reasons why these indicators are valuable for your business or for analysing a customer:
- They provide a clear picture of a company’s financial situation.
- They improve long-term debt management.
- They help prevent unpaid invoices.
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What is a solvency ratio and how does it work?
A solvency ratio measures a company’s ability to meet its financial obligations. These ratios are often expressed as percentages and are calculated by comparing a company’s equity with its liabilities.
In practice, solvency ratios indicate whether a business can repay its debts over different time horizons.
They are mainly used by financial institutions such as banks to evaluate the creditworthiness of borrowers and determine whether they are likely to repay loans. A company seeking new financing can also rely on solvency ratios to reassure potential investors. Strong ratios demonstrate financial stability and reduce perceived risk.
In a credit risk management context, solvency ratios are equally useful. If you have access to sufficient financial data about a prospect or customer, you can determine whether they are capable of paying their outstanding invoices. Just as a bank would evaluate a borrower before granting credit.
The three main solvency ratios used in financial analysis
There are three key solvency ratios used in financial analysis:
- The current ratio, which measures a company’s ability to meet its short-term liabilities
- The debt repayment capacity ratio, which evaluates a company’s ability to repay all its debts
- The financial autonomy ratio, which measures a company’s financial independence from external financing
The current ratio: solvency ratio formula for short-term liquidity
The current ratio, sometimes referred to as the working capital ratio, allows finance teams to determine whether current assets cover current liabilities. It measures a company’s ability to meet short-term obligations.
There are two common ways of calculating the solvency ratio formula for liquidity:
Current ratio formula:
(Current assets - inventory) / short-term liabilities
or
(Customer receivables + cash) / short-term liabilities
Whichever solvency ratio formula you use, the result should generally be above 1. If it is lower, the company may struggle to repay its short-term debts.
Ideally, the current ratio should be around 2 or 3, although this benchmark can vary depending on the industry.
Debt repayment capacity ratio: calculating solvency ratio for debt sustainability
A company’s debt repayment capacity reflects its ability to repay all its debts using internally generated resources. This involves comparing its net debt with its cash flow capacity.
The formulas used when calculating solvency ratios in this context are:
Net debt = financial debt - cash
Cash flow capacity = net accounting profit + depreciation and provisions - reversals of depreciation and provisions + book value of disposed assets - proceeds from asset sales - share of subsidies transferred to the income statement
Which gives the following formula:
Debt repayment capacity ratio = net debt / cash flow capacity
This ratio generally falls between 2 and 4, depending on the sector.
If the ratio exceeds this threshold, the company may struggle to reduce its debt through its normal business activity. In that case, banks and investors may be less willing to provide new financing.
Financial autonomy ratio: measuring financial independence
The financial autonomy ratio measures how independent a company is from external financing. The aim is to determine whether the business can grow without relying excessively on outside investment.
The solvency ratio formula is straightforward:
Financial autonomy ratio = equity / financial debt
This ratio compares a company’s debt with its equity.
If the ratio is above 1, the company benefits from strong financial independence. If it falls below 1, the company may face difficulties raising additional financing.
Excessive reliance on external funding creates uncertainty about a company’s future. If its main sources of investment withdraw, the company may struggle to operate independently and could be forced to reduce costs.
How to interpret solvency ratios correctly
The three solvency ratios described above highlight different aspects of a company’s financial health. As a result, the insights they provide can vary.
Individually, each ratio offers valuable information about one dimension of a company’s finances. However, it is important to analyse them together in order to obtain a reliable assessment.
For example, if you only calculate the current ratio, you are observing the company’s financial position at a specific moment in time. This situation can evolve over the long term and may not fully reflect the company’s underlying financial strength.
When conducting this analysis for a potential customer, the context of your business relationship should also influence your interpretation.
If the customer is placing a one-off order, short-term solvency may be sufficient.
However, if you are entering into a long-term commercial relationship, it is essential to analyse the company’s long-term solvency as well. This helps you avoid unpleasant surprises several months down the line.
How to improve solvency ratios and financial stability
For a company to remain solvent, its commercial activity must grow over time. Stagnation or declining activity increases the risk of insolvency.
Improving solvency ratios therefore helps businesses maintain financial stability, secure financing and repay debt more easily.
Several actions can help improve these indicators:
- reduce payment delays
- optimise inventory management to improve working capital
- reduce debt levels to ensure obligations can be honoured
Calculating solvency ratios, whether for your own company or for your customers, is essential. These indicators help anticipate financial risks and avoid future difficulties.
Weak solvency ratios are often an early warning sign of a company approaching financial distress. Conversely, strong solvency ratios indicate that a business is capable of covering its debts and operating with confidence.
FAQ on solvency ratios
What is the difference between liquidity ratios and solvency ratios?
Liquidity ratios measure a company’s ability to pay its short-term obligations, usually within one year. Solvency ratios, on the other hand, assess whether a company can meet its long-term financial commitments.
While liquidity focuses on immediate cash flow, solvency evaluates the overall financial stability of a business.
Can solvency ratios predict financial distress?
Solvency ratios cannot predict bankruptcy with certainty, but they can act as early warning indicators.
A declining solvency ratio or excessive leverage may signal that a company is becoming financially fragile and could struggle to meet its obligations.
Do solvency ratios vary by industry?
Yes. The interpretation of solvency ratios often depends on the industry structure and capital intensity.
For example, capital-intensive sectors such as manufacturing or infrastructure typically operate with higher levels of debt than service-based industries.
How often should companies analyse solvency ratios?
Most companies review solvency ratios quarterly or annually, often alongside financial statements.
However, businesses that manage credit risk or large customer portfolios may analyse solvency indicators more frequently to monitor financial exposure.
Can solvency ratios help evaluate customer risk?
Yes. Businesses can use solvency ratios to assess whether a customer is financially capable of paying invoices.
Combined with credit reports and payment history, these indicators help reduce the risk of late payments or bad debt.
What are the limitations of solvency ratios?
Solvency ratios are useful indicators but they should never be analysed in isolation. They are based on accounting data from financial statements, which may not reflect recent changes in a company’s financial situation.
For a more accurate assessment, solvency ratios should be analysed alongside cash flow indicators, liquidity ratios and industry benchmarks.
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