The solvency ratio: calculation and reading

The official definition

The Central Balance Sheet Office of the National Bank computes a single solvency ratio, no. 19 in its list, with no computation condition:

Solvency = equity (10/15) ÷ total liabilities and equity (10/49) × 100

Since total liabilities and equity equals total assets (20/58), the formula is often read as "equity over balance sheet total". The IBR-IRE study calls the same ratio the degree of financial autonomy: when this ratio rises, the financing of the company depends less on borrowed capital overall.

Both amounts are read directly on the balance sheet, in every format (full, abridged and micro). The result is expressed as a percentage.

The prudent version

Analysts often remove from the numerator the assets whose value is most uncertain in case of difficulty. FinScan applies this version:

Prudent solvency = (10/15 − 21) ÷ 20/58

where 21 designates intangible fixed assets: software developed in-house, patents, goodwill, capitalised development costs. A EUR 300,000 goodwill in a company showing EUR 350,000 of equity changes the reading completely.

Company law reasons the same way. For the alarm bell procedure, the Commission for Accounting Standards recalls that net assets are computed as total assets less provisions, debts and, except in exceptional cases to be justified in the notes, formation expenses and research and development costs not yet amortised (CBN opinion 2021/14).

What it measures

A company's balance sheet is financed in two ways: by its equity, which does not have to be repaid, and by debt, which does. Solvency is the share of the former.

A solvent company can absorb losses, negotiate with its bank, get through a bad year. A weakly solvent company depends on the patience of its creditors: a supplier who demands payment, a bank that refuses to extend a credit line, and the situation tightens.

The benchmarks

There is no legal norm, but two documented benchmarks:

• The National Bank's threshold. When the NBB checks the economic and financial capacity of companies bidding for its public contracts, it requires three things: solvency above 20% computed as (10/15) ÷ (10/49), broad liquidity above 1, and positive equity.
• The Belgian average. The IBR-IRE study on analysis by the ratio method states that on average, for companies in Belgium, the degree of financial autonomy reaches about 30%. The study is not recent: the value gives an order of magnitude, not a norm.

FinScan, for its part, colours solvency red below 10% and amber below 30% on every company page. These are its own vigilance thresholds, not an accounting rule.

The sector matters a lot. A real estate or industrial company carries heavy assets often financed by borrowing; a consulting firm has few assets and little debt. This is why the Central Balance Sheet Office publishes its ratio statistics by sector and in quartiles: the first reflex is to place the company between the first quartile, the median and the third quartile of its activity.

The nature of the debt

The IBR-IRE study insists: as much as the overall share of the balance sheet financed by third-party funds, it is their very nature that conditions solvency. Three families can be read in the liabilities and the notes:

• Debts arising from operations (suppliers, advances received) are the most benign: they renew themselves at the pace of activity and take on a kind of permanent character.
• Loans of more than one year (heading 17) offer stable financing, but with binding instalments; they are most often secured, with details in the notes (breakdown of long-term debt by residual maturity, secured amounts).
• Financial debts within one year are the most demanding: they must be renewed or repaid within the year.

Two other items complete the solvency diagnosis according to the IBR-IRE: off-balance-sheet rights and commitments (guarantees given, litigation) and overdue debts to the tax authorities and social security, disclosed in the notes of the full format.

Solvency and repayment capacity

Correct solvency does not say whether the company can repay. For that, the IBR-IRE relates the cash flow of the year to third-party funds:

Coverage of third-party funds by cash flow = cash flow ÷ (16 + 17 + 42/48 + 492/3)

and, more specifically, to long-term third-party funds only (16 + 17). The guide on cash flow details the NBB computation of cash flow.

Reading the trend

An isolated ratio says little. The filing always contains the previous year: compare.

• Solvency that falls while the company is profitable may signal large dividends, a share buyback or new borrowing to invest.
• Solvency that falls with losses signals that equity is eroding. If it approaches zero, the guide on negative equity describes what the law then requires of directors.
• Solvency that rises without profit often comes from a capital increase or a debt waiver by a shareholder: useful, but to be distinguished from an improvement of the business.

The pitfalls

• A recent capital increase improves the ratio without saying anything about profitability.
• Shareholder current accounts are debts on the balance sheet, even when they are as stable as equity. Only the notes say whether they are subordinated.
• Revaluation surpluses (heading 12) inflate equity without any cash contribution.
• A balance sheet just closed may be dressed up by a one-off year-end transaction.