The Solvency ratio is a measure to analyze the long-term liquidity risk of an entity. The Basel III accord recommends a minimum of 8% capital reserve requirements for all banks for better liquidity risk management.
Solvency ratio is often considered a similar term to liquidity ratio. However, both these terms measure the cash flows, liquidity, and financial stability with different approaches.
Let’s discuss what is the solvency ratio and how it is important for banks.
The term solvency refers to the financial viability of an individual, business, or government entity.
An entity is said to be financially solvent when it has more assets than liabilities. Specifically, it refers to the ability of an entity to meet its total liabilities in the long term.
Therefore, a solvency ratio is a financial metric that measures the assets or cash flows of an entity as compared to its total liabilities or debt obligations.
When analyzing a business’s financial stability, the term solvency usually refers to the ratio of the net cash flows of the business to its long-term debt obligations.
The Basel III accord guides the adequate solvency level a bank must maintain. The minimum capital adequacy requirement for banks under the Basel III accord is now 8%.
Other entities can derive their adequate solvency ratios by analyzing industry-specific risks and trends.
The Basel III accord provides guidelines on liquidity, capital adequacy, and solvency measurement rules for banks.
It proposed a 100% liquidity coverage ratio rule for banks. It means all banks must maintain a 1:1 ratio for their current obligations and cash flows.
Similarly, banks are required to maintain an 8% capital adequacy ratio. Banks also require maintaining an adequate solvency ratio.
Under the Basel III recommendations, banks calculate their solvency ratios by using the regulatory capital and weighted-average risk assets.
The formula to calculate the risk-based capital adequacy for banks is given below.
Risk-Based Capital Adequacy Ratio = Regulatory Capital / Weighted-Risk Assets
The Basel III accord has increased the proportion of equity capital from 2.5% to a minimum of 4% in the weighted-risk assets calculations.
Similarly, it has introduced a new credit rating approach to convert traditional ratings into a comprehensive risk-assessment approach.
It now assigns a percentage risk score to each asset class that banks can use to calculate the total risk-weighted assets for all of its asset classes.
For example, US government-issued securities have a risk score of 0% due to the highest level of security and backing.
Similarly, residential mortgages backed by the US government entities are assigned a score in the range of 35 to 100% depending on their risk assessments.
Banks can use the formula given above to calculate their solvency ratios. Other entities use a combination of different financial ratios to measure the liquidity and solvency risks.
The general equation to assess the solvency risk of a non-banking entity can be written down as:
Solvency Ratio = (Net Income + Depreciation/Amortization)/ Current + Long-term Liabilities
Banks have to calculate the capital adequacy ratio by calculating the regulatory capital and risk-weighted assets.
The total capital of banks is divided into tier 1 and tier 2 capital classes depending on their classification.
The equity capital is included in tier 1 along with ordinary share capital, audited bank reserves, and intangible assets.
The tier 2 capital unaudited retained earnings and reserves as well as absorbed losses of a bank.
The risk-weighted assets refer to the total composition of assets of a bank according to the risk scores assigned as guided by the Basel III accord.
Then, the total score of these assets is calculated by including all asset classes of the bank.
The solvency ratio for banks determines their long-term financial health in terms of meeting their debt obligations.
It is often used in conjunction with a liquidity risk analysis of banks. The Basel III accord stresses controlling the short-term and long-term liquidity risks of banks through these metrics.
Although a bank’s ability to meet its current liabilities is important, its long-term financial strength determines the viability of its operations and ultimately survival.
Therefore, a bank can achieve a healthy solvency ratio by maintaining a positive capital adequacy ratio and controlling the risk-weighted assets.
It means investing in the right type of securities and arranging secured debt instruments are equally important for banks to maintain their short-term and long-term financial credibility.
Along with the capital adequacy ratio to measure the solvency of banks, analysts use several other types of solvency ratios as well.
Interest Coverage Ratio
It compares the total interest payments for an entity to its current net cash flows. It is the ability of an entity to pay interest payments from its operating cash flows.
Debt Service Coverage Ratio
The debt service coverage ratio includes interest payments and the principal portion of the debts of an entity.
It measures the ability of an entity to pay debt payments including principal repayments from its net cash flows.
This ratio measures the ability of an entity to utilize its assets to manage debts. It links total assets to the total debt obligations of an entity.
The equity ratio compares the total equity and total debt of an entity. It helps analysts analyze the level of debt of an entity against the equity contributions of shareholders.
The major difference between solvency and liquidity ratios is the timeframe of analysis.
Liquidity ratios measure the short-term financial strength of an entity while solvency ratios measure the long-term financial health.
Therefore, while both metrics determine the financial viability of an entity, they measure similar factors in different ways.
The current ratio is a measure that compares current assets to the current liabilities of an entity. It is a simple but effective measure to asses the short-term liquidity of an entity.
A current ratio of 2:1 is usually considered an adequate current ratio.
The quick ratio uses a redefined metric to current ratio factors. It includes quick assets by excluding inventory from current assets.
This approach makes the quick ratio a better measure of liquidity analysis.
While the solvency and profitability of an entity may seem the same terms, they are essentially both different.
The solvency of an entity is the ability to meet its debt obligations from its capital and cash flows.
Profitability ratios measure the ability of an entity to generate profit by utilizing the available resources.
Solvency measures the financial strength of an entity in terms of repaying debts while profitability relates to generating income and minimizing losses.
The solvency ratio has several advantages for banks and non-banking entities.
- Banks need to comply with regulatory frameworks like the Basel III accord to maintain adequate capital requirements.
- Banks and non-banking entities can assess their financial risks through solvency ratios, liquidity ratios, and capital adequacy metrics.
- Solvency ratios help an entity in strategic planning and forecasting for borrowing, investments, and dividend decisions.
- Entities can use liquidity and solvency ratios in conjunction to analyze and monitor liabilities.
- The Solvency ratio can help in setting up monthly budgets, cash flow forecasting, and strategic planning.
- The Solvency ratio is a key metric for investors, shareholders, and lenders.
Solvency ratios have a few disadvantages as well.
- The solvency ratio does not measure the ability of an entity to refinance, debt restructuring, or new debt acquisition abilities.
- An entity with an adequate level can still show a risky solvency ratio due to mismanagement of cash flows.
- A single solvency ratio cannot depict the full picture of the financial strength of an entity.
- Like any other financial ratio, it requires analysis over a series of observations to establish trends.
Accounting adjustments for cash flows, risk-weighted assets, and capital structuring can be used to manipulate solvency ratios.