The Key Solvency Ratios and How to Use Them

A company’s solvency is measured with ratios that compare its debts to its assets, its equity and its earnings. The most widely used are the debt-to-equity ratio, the debt ratio, the debt-to-capital ratio and the interest coverage ratio, each drawn from the company’s financial statements.

Solvency is a company’s ability to meet its long-term obligations and keep operating as a going concern. A solvent company owns more than it owes and earns enough to service its debt, while an insolvent company cannot cover what it owes.

The FRC dictionary entry on solvency gives the core definition. This guide explains how solvency is measured in practice: the key ratios with worked calculations, how solvency differs from liquidity, what happens when a company becomes insolvent, how solvency applies to investment advisers themselves, the exam traps and five practice questions.

Where This Topic Appears on the Exams

Solvency is tested in the economic factors and business information section of the Series 65, within financial statement analysis. Questions usually ask candidates to calculate a ratio, to identify whether a ratio measures solvency or liquidity, or to interpret what a high or low figure means.

FRC’s Series 65 Exam Preparation course covers financial statements and ratio analysis chapter by chapter, and the Series 65 needs no sponsoring firm. The Series 7 Exam Preparation course covers fundamental analysis of companies and their bonds, and the SIE Examination Preparation course introduces the financial statements and the risks investors face.

Every FRC course can be spread across interest-free monthly payments, so cost is no reason to delay. Ratio questions are quick marks once the formulas are memorized, and losing them to a mix-up between solvency and liquidity is avoidable.

Where the Numbers Come From

Solvency ratios draw mainly on two financial statements. The balance sheet shows what the company owns, what it owes and the shareholders’ stake at a single point in time.

The income statement shows revenue, expenses and profit over a period, including the interest the company pays on its debt. The cash flow statement adds a view of the actual cash coming in and going out.

FRC’s guide to income statement vs balance sheet explains the difference between the two main statements. The balance sheet follows a simple equation: assets equal liabilities plus shareholders’ equity.

Solvency vs Liquidity

Solvency and liquidity are related but measure different things. Solvency looks at the long term, asking whether the company’s total assets and earnings can support its total debts over time.

Liquidity looks at the short term, asking whether the company has enough cash and near-cash assets to pay the bills due within the next year. A company can be solvent but illiquid, owning valuable property but lacking cash to pay this month’s suppliers.

A company can also be liquid but heading towards insolvency, with cash on hand today but debts far larger than its assets. The exam frequently tests this distinction, so learn which ratios belong to which group.

The Debt-to-Equity Ratio

The debt-to-equity ratio compares what the company has borrowed with what its shareholders have invested. It is calculated by dividing total debt, or in some versions total liabilities, by shareholders’ equity.

A ratio of 1.0 means the company is financed equally by creditors and shareholders. A higher ratio means the company relies more on borrowed money, which raises the risk that it could struggle to meet its obligations in a downturn.

There is no single correct level. Utilities and other businesses with steady, predictable revenue often carry higher ratios safely, while companies with volatile earnings usually need lower ones.

The Debt Ratio

The debt ratio divides total liabilities by total assets. It shows what share of the company’s assets is financed by creditors rather than shareholders.

A debt ratio of 0.60 means 60% of the company’s assets are funded by liabilities. The closer the ratio gets to 1.0, the thinner the cushion of equity protecting creditors.

A ratio above 1.0 means liabilities exceed assets. On a balance sheet basis, that company is insolvent, because selling everything it owns would not cover everything it owes.

The Debt-to-Capital Ratio

The debt-to-capital ratio, sometimes called the bond ratio or debt-to-total-capitalization ratio, focuses on the company’s long-term funding. It divides long-term debt by the sum of long-term debt and shareholders’ equity.

This ratio shows how much of the company’s permanent capital structure comes from bonds and other long-term borrowing. A company with a high bond ratio is described as highly leveraged.

Bond investors watch this ratio closely. The more debt sits in the capital structure, the more claims compete for the company’s cash flow if business turns down.

The Interest Coverage Ratio

The interest coverage ratio, also called times interest earned, divides earnings before interest and taxes, known as EBIT, by the annual interest expense. It shows how many times over the company could pay its interest bill from operating earnings.

A coverage ratio of 4 means operating earnings are four times the interest due. A ratio close to 1 means almost all earnings go to interest, leaving little margin if profits fall.

This ratio links solvency to profitability. A company with modest debt but collapsing earnings can see its coverage fall quickly, even if its balance sheet looks sound.

Worked Example: Calculating Solvency Ratios

A company reports total assets of $500 million, total liabilities of $300 million and shareholders’ equity of $200 million. Its long-term debt is $200 million, its EBIT is $60 million and its annual interest expense is $15 million.

The debt-to-equity ratio, using total liabilities, is $300 million divided by $200 million, or 1.5. The debt ratio is $300 million divided by $500 million, or 0.60.

The debt-to-capital ratio is $200 million divided by $400 million, or 50%. The interest coverage ratio is $60 million divided by $15 million, or 4 times, meaning the company earns four times its interest bill.

Worked Example: Liquid but Not Solvent

A second company holds $80 million in cash and other current assets against $40 million of current liabilities, giving a current ratio of 2.0. On a short-term view, it can comfortably pay its bills.

However, it also carries $600 million of long-term debt, and its total assets are only $550 million. Its liabilities exceed its assets, so it is insolvent on a balance sheet basis despite its strong short-term position.

This is the type of scenario the exam uses to test whether candidates can separate the two ideas. Strong liquidity today does not guarantee long-term solvency.

The Liquidity Ratios to Keep Separate

The current ratio divides current assets by current liabilities, and the quick ratio, or acid-test ratio, does the same after removing inventory from current assets. Both are liquidity measures, not solvency measures.

Working capital, calculated as current assets minus current liabilities, is also a liquidity measure. It shows the cushion available to meet obligations due within a year.

On the exam, any ratio built on current assets and current liabilities measures liquidity. Ratios built on total debt, long-term debt, equity or interest coverage measure solvency.

Comparing Companies and Industries

Solvency ratios are most useful when compared against something. Analysts look at a company’s ratios over several years to see whether its debt load is rising or falling.

They also compare a company with others in the same industry. A debt-to-equity ratio that looks high for a software company may be normal for an electric utility with regulated, steady revenue.

Rapid changes deserve attention. A sharp rise in leverage or a steep fall in interest coverage can signal that a company is taking on more risk than its earnings can support.

Solvency and Credit Ratings

Rating agencies use solvency measures as a core input when assigning a credit rating to a company and its bonds. Strong coverage and moderate leverage support higher ratings, while heavy debt and thin coverage lead to lower ones.

Bonds rated BBB- by Standard & Poor’s or Baa3 by Moody’s and above are considered investment grade, and those below are high-yield, sometimes called junk. Lower ratings mean higher credit risk and higher yields to compensate investors.

FRC’s guide to investment-grade vs high-yield bonds explains how credit quality shapes a bond’s risk and return. A downgrade often follows a deterioration in solvency ratios.

When a Company Becomes Insolvent

A company is insolvent on a balance sheet basis when its liabilities exceed its assets. It is insolvent on a cash flow basis when it cannot pay its debts as they fall due, even if its assets are worth more on paper.

An insolvent company may default on its bonds and loans, and it may seek protection through bankruptcy. Under the US Bankruptcy Code, Chapter 11 allows the company to reorganize and continue operating, while Chapter 7 leads to liquidation.

In a liquidation, claims are paid in order of priority. Secured creditors come first, followed by unsecured creditors such as general bondholders, then subordinated debt holders, then preferred stockholders, with common stockholders last.

What Insolvency Means for Investors

Common stockholders face the greatest risk in an insolvency, because they are paid only after every creditor and preferred stockholder. In many cases, they receive nothing.

Bondholders usually recover something, but the amount depends on where their bonds sit in the priority order and whether they are secured by specific assets. A secured bond backed by property is generally safer than an unsecured debenture.

Solvency analysis is therefore useful to every type of investor in a company. It shows how much risk sits between each investor and a full recovery of their money.

Solvency for Investment Advisers

Solvency is not only a tool for analyzing companies. State securities regulators also set financial requirements for investment advisers themselves, because an adviser in financial trouble may be unable to meet its commitments to clients.

Under the NASAA model rules, a state-registered adviser with custody of client funds or securities generally must maintain a minimum net worth of $35,000, and an adviser with discretionary authority but no custody must maintain $10,000. An adviser that accepts prepayment of more than $500 in fees, six or more months in advance, must maintain a positive net worth.

Advisers must also disclose any financial condition reasonably likely to impair their ability to meet contractual commitments to clients if they have discretion, have custody or require substantial prepayment of fees. FRC’s guides to what custody is for an investment adviser and what the brochure rule is explain the related requirements.

The Limits of Solvency Ratios

Solvency ratios rely on accounting figures, which may not reflect what assets would actually fetch in a sale. A factory or a brand recorded at one value on the balance sheet could be worth far more or far less to a buyer.

Some obligations, such as certain leases, pension promises or guarantees, may not be fully captured in the headline debt figures. Analysts read the notes to the financial statements to find them.

Ratios are also a snapshot of the past. A company’s solvency can change quickly if its earnings fall, interest rates rise or a large debt comes due, so the ratios must be updated and read alongside the company’s outlook.

Solvency for Broker-Dealers

Broker-dealers face their own solvency rules because they hold customer cash and securities. The SEC’s net capital rule, Rule 15c3-1, requires each broker-dealer to keep a minimum amount of liquid capital so it can meet its obligations to customers and other firms.

If a broker-dealer does fail, the Securities Investor Protection Corporation protects customer accounts up to $500,000, including up to $250,000 in cash. SIPC protection covers missing assets when a firm fails, not losses from falling market prices.

These rules show that regulators treat solvency as a client protection issue. A firm that cannot meet its own obligations puts its customers’ assets at risk.

Solvency for Individual Clients

The same idea applies to individual clients. A client whose assets exceed their liabilities has a positive net worth, while a client who owes more than they own has a negative net worth.

Advisers review a client’s personal balance sheet as part of the client profile. FRC’s guide to net worth vs liquid net worth explains how these figures are calculated and used.

As with companies, a client can be solvent but short of cash. FRC’s guide to what liquidity is in a client profile covers that side of the picture.

The Exam Traps

The first trap is confusing solvency with liquidity. Solvency is about long-term obligations, while liquidity is about bills due within a year.

The second trap is placing the current ratio or quick ratio under solvency. Both are liquidity ratios, because they use current assets and current liabilities.

The third trap is reading a high debt-to-equity ratio as always bad. Some industries operate safely with high leverage, so ratios must be compared within the same industry.

The fourth trap is getting the liquidation order wrong. Common stockholders are paid last, after all creditors and preferred stockholders.

FRC’s guide to Series 65 economics questions and exam traps covers more traps in this area. For the full list, see FRC’s guide to Series 65 exam traps and common mistakes.

A Memory Aid

Remember “current means liquid, long-term means solvent.” If a ratio uses current assets and liabilities, it measures liquidity, and if it uses total or long-term debt, equity or interest coverage, it measures solvency.

For the liquidation order, use “secured, unsecured, subordinated, preferred, common.” The further down the list, the greater the risk of receiving nothing.

Practice Questions

Question one: a company has total liabilities of $400 million and total assets of $500 million. What is its debt ratio? 0.80, meaning 80% of its assets are financed by liabilities.

Question two: a company has EBIT of $50 million and interest expense of $10 million. What is its interest coverage ratio? 5 times.

Question three: is the quick ratio a solvency or a liquidity measure? A liquidity measure.

Question four: what is the minimum net worth generally required under the NASAA model rules for a state-registered adviser with custody? $35,000.

Question five: in a liquidation, who is paid last? Common stockholders.

Get Exam-Ready

Solvency questions reward candidates who know the formulas and can place each ratio in the right group. Once “current means liquid, long-term means solvent” is fixed, these questions become quick, dependable marks.

The FRC dictionary is more than a dictionary. It is a library of explainer videos, written explanations and on-page quizzes covering the FINRA and SEC rules you are tested on, so you can open any term, such as return on equity, and go deeper whenever a question catches you out.

Study With FRC

FRC’s programs and memberships are open to everyone. Whether you are preparing for the Series 65, the Series 7, the SIE or a combination, structured exam preparation turns topics like solvency into marks you can rely on.

FRC’s Professional Membership adds verified progress and a Digital Profile, so when you apply to advisory firms, hiring managers can see your exam progress and the knowledge you are building, not just read about it on a resume.

Your Next Step

A company’s solvency is measured with the debt-to-equity ratio, the debt ratio, the debt-to-capital ratio and the interest coverage ratio, which together show whether it can support its long-term obligations. Solvency differs from liquidity, which looks only at short-term bills, and the same principles apply to advisers and individual clients.

Remember “current means liquid, long-term means solvent,” and you will be ready for every version of this question the exam can ask.