How to calculate your solvency ratio
If you are a business owner looking for a loan, your lender will look for your credit ratio. Of course, if you have a startup and are new to running a business, you might not know what a solvency ratio is – but your lenders will be watching it carefully. The health of your solvency ratio will likely determine whether you get a Business loan. Getting business credit isn’t always easy, but it can be important if you need to borrow to finance a business. You can work with a Financial Advisor to help you create a financial plan and get your credit on the right track.
What is a solvency ratio?
It is a mathematical equation or formula that determines whether a company cash flow flows regularly enough for the business to repay the money it borrows. (You’ve probably heard business people ask questions like, “Is your business solvent?” Well, a solvency ratio answers that question.)
A lender looks at the liabilities and assets of the owner of the business and how the assets are depreciating and ultimately decides whether the solvency ratio of that business is financially sound or weak. If it’s strong, your company will probably get the loan and if it’s weak, it probably won’t – or the terms of the ready will not be very good, like the fact that you are struggling with a high interest rate.
The solvency ratio is an imperfect way for a lender to determine a company’s ability to repay a debt. For example, it doesn’t take into account an existing line of credit you might use to pay off debt or stocks you might sell to pay off debt. But for better or worse, lenders like to know a company’s solvency ratio.
How to calculate your solvency ratio
Lenders will do this when they analyze your balance sheets; you won’t have to crunch the numbers. But you might want to know how to calculate your business’s solvency ratio, so that your expectations match the likelihood of you getting a business loan. First, a disclaimer that this is about to get math heavy, but if you want to calculate it, there are four main types of credit ratios that lenders look at.
1. Interest coverage ratio
Can your business handle interest payments on the debt? This is determined by the interest coverage ratio.
Math: Interest coverage ratio=EBIT/Interest expense. (EBIT is earnings before interest and taxes)
The answer you are looking for: Some lenders like to see the number 2, but others prefer to see 3 or more. For example, if your company’s earnings before interest and taxes are $300,000 and you owe $50,000 in interest, your interest coverage ratio would be 6. In this case, your company should have no problem repaying this debt.
2. Debt to asset ratio
Who owns what? This ratio looks at how much of your business is owned by the people your business owes money to, versus how much of the business is owned by its shareholders.
Math: Debt/assets=assets/debt ratio
The answer you are looking for: If you do the math and end up with a 1 or less, that’s what lenders like to see. If your number is less than 1, you have more assets than liabilities and your business probably has a fairly good credit risk.
3. Equity Ratio
How healthy is your business? It is mainly funded by equity or by debt? This is what lenders want to know when researching your business’s equity ratio.
Math: Equity Ratio=Total Equity/Total Assets
The answer you are looking for: You’ll be looking for a percentage in this case, and the higher the percentage, the better. If your calculations show you have, say, 80% or more, a lender will be pretty happy. That would mean 20% of your business is in debt. When you have 50% or less, that’s when a lender gets uncomfortable. You have a lot of debt and are considered highly leveraged.
4. Debt ratio
How much debt do you use to run your business, compared to your own capital? This may sound awfully similar to the equity ratio, but as you’ll see, the calculation is a little different.
Math: Debt/equity ratio=Outstanding debt/equity
The answer you are looking for: You’re looking for a number less than 1. Let’s say your business has $100,000 in equity and you have $30,000 in liabilities. If so, you would divide $30,000 by $100,000 and you would get 0.3. A lender would probably be quite happy with that number.
A word on liquidity ratios
Liquidity ratios are often mentioned in the same breath as solvency ratios because these also measure the health of a business and, like solvency ratios, there are many different types of liquidity ratios. In the case of a liquidity ratio, lenders are interested in the short-term health of the company. Ideally, you want both ratios to be healthy and strong, but more importantly you want the solvency ratio to be attractive.
Lenders tend to look carefully at the liquidity ratios of loans, especially if they are considered high risk. They want to know how much money you have on hand to repay the loan if you’re having trouble doing so. have you cash? Inventory for sale? But, at least in theory, the lender may not care as much as your business liquidity the ratios are not very strong if the solvency ratios look attractive.
Credit ratios probably aren’t something you think about often, especially if you’re new to running a business, but lenders do. It’s a good idea to understand them, even if you’re not currently in the market for a loan. If you analyze your solvency ratios and discovering that they are not in good shape can motivate you to improve the financial health of your business. It’s good for your business, whether you ever want to get a loan or not.
Tips for building credit
Establishing your credit as an individual or business can be time consuming and sometimes confusing. It’s not always easy to maximize your results, other than paying your bills on time. A financial advisor can help you create a comprehensive financial plan, which includes how you can maximize your ability to qualify for more credit. Finding the right financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is best for you. If you’re ready to find an advisor who can help you reach your financial goals, start now.
Business credit can be even harder to get because there isn’t such a clear way to get it. You can learn more by reading our article on how you can establish and build your business credit.
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