Solvency Ratios: How to Evaluate a Company’s Long-Term Financial Stability
Solvency ratios help investors assess whether a company can survive over the long term. They reveal how much debt a company carries and whether it has the financial muscle to meet future obligations. While liquidity ratios deal with the short term, solvency ratios are about resilience, risk, and capital structure over years, not quarters.
In this article, we’ll explore the most essential solvency ratios, interpret their meaning in bull and bear markets, and walk through detailed examples to show how these ratios help separate robust businesses from those built on shaky ground.
What Are Solvency Ratios?
Solvency ratios measure a company’s ability to meet long-term debt obligations. They reflect how the company is financed (debt vs. equity) and how easily it can cover fixed financial charges like interest payments.
Key Solvency Ratios Explained
1. Debt-to-Equity Ratio (D/E)
Formula: Total Liabilities / Shareholders’ Equity
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Indicates how much debt is used to finance the company relative to equity.
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High D/E may suggest aggressive leverage but can also amplify returns in capital-efficient businesses.
Example:
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A D/E of 2.0 means the company uses $2 of debt for every $1 of equity.
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Asset-light tech firms may have D/E < 0.5, while capital-intensive utilities may run 2.0–3.0.
2. Interest Coverage Ratio
Formula: EBIT / Interest Expense
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Measures how many times a company can cover its interest payments with its operating income.
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A ratio < 1.5 may suggest financial stress.
Example:
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Company A has EBIT of $300M and interest expenses of $100M → interest coverage = 3.0.
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Company B has EBIT of $90M and interest expenses of $80M → coverage = 1.125, a red flag.
3. Debt Ratio
Formula: Total Liabilities / Total Assets
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Tells you how much of the company’s assets are financed by debt.
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The higher the ratio, the more leveraged the firm.
Example:
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A debt ratio of 0.7 means 70% of the company’s assets are funded through debt.
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Compare this across time and against competitors.
4. Equity Ratio
Formula: Shareholders’ Equity / Total Assets
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Complements the debt ratio by showing how much of assets are financed by shareholders.
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A higher equity ratio suggests lower long-term financial risk.
Note: Equity Ratio + Debt Ratio = 1 (in theory)
Market Context: Interpreting Solvency Ratios Through the Cycle
📈 Bull Market
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Investors may overlook high leverage if revenue and earnings are growing fast.
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D/E ratios rise as firms borrow to expand or buy back shares.
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Interest coverage remains healthy due to rising EBIT.
Example:
A SaaS firm borrows $500M to fund growth. D/E jumps to 1.2, but interest coverage is 10x due to strong margin expansion. In a bull market, this is often seen as bold but justifiable.
📉 Bear Market
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High leverage becomes a concern as earnings decline.
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Interest payments become harder to cover.
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Companies with poor solvency ratios may face downgrades or bankruptcy.
Example:
A consumer discretionary firm sees EBIT drop 40%. Its interest coverage falls from 4.5x to 1.8x, raising default concerns. The D/E of 2.5 now looks dangerous.
✨ Recovery or Transition Phase
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Firms that maintained conservative leverage during the downturn outperform.
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Rising interest coverage and deleveraging become bullish signals.
Sector Benchmarks and Sensitivity
Red Flags to Watch
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D/E rising rapidly without corresponding revenue or profit growth
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Interest coverage < 2.0 consistently, especially in cyclical sectors
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Debt maturity wall—large portions of debt due in near-term years
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Declining equity base due to losses or buybacks while debt remains steady
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Covenant breaches noted in financial statement footnotes
Case Study: Two Companies, Same Sector
Company A (Industrial Equipment)
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D/E: 0.9
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Interest Coverage: 6.2x
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Debt Ratio: 45%
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Equity Ratio: 55%
Uses leverage responsibly. EBIT easily covers interest. Lower risk.
Company B (Industrial Equipment)
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D/E: 2.4
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Interest Coverage: 1.3x
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Debt Ratio: 70%
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Equity Ratio: 30%
Highly leveraged. Interest payments are a burden
