Maintaining a sound financial position is crucial for a company's growth. A company's solvency informs our investment decisions. It's better for investors to avoid companies struggling to pay off their debts as they may face the risk of bankruptcy due to disrupted capital flows. Generally, we use four indicators to measure a company's creditworthiness.

1. Debt-to-Asset Ratio

The debt-to-asset ratio defines the proportion of a company's debt to its assets, reflecting its potential ability to meet its obligations. The formula for calculating this ratio is to divide total debts by total assets. Companies with heavy assets or poor cash flow often need to rely on debt to sustain operations, resulting in a higher debt-to-asset ratio. On the other hand, companies with lighter assets or better cash flow tend to have a lower debt-to-asset ratio. A debt-to-asset ratio below 50% may appear more attractive, however, there is no ideal ratio. Many factors need to be considered when looking at the ratio including the industry and type of debt funding.

2. Current Ratio

It measures a company's ability to pay off its short-term obligations and is calculated by dividing current assets by current debts. Current assets refer to assets that can be converted to cash within a year, while current debts are obligations that should be repaid within a year. Essentially, the current ratio measures how many times a company's current assets can cover its current debts. A current ratio of 3 may indicate a company has enough current assets to cover its current liabilities with a margin of safety.

3. Quick Ratio

It is calculated by subtracting inventories and prepaid expenses from current assets and dividing the result by current liabilities. It is a more stringent liquidity metric because inventory may be difficult to convert quickly to cash and its prepaid expenses may not be refundable. A current ratio of 2 may indicate a company has enough liquid assets to cover its current liabilities with a higher margin of safety.

4. Cash Ratio

It is calculated by dividing a company’s cash and cash equivalents by its current liabilities. The ratio is considered the most conservative metric of creditworthiness because cash and cash equivalents are readily available to meet obligations. A higher-than-1 cash ratio may be considered desirable.

However, it's important to note that some companies may have sufficient cash reserves, such as Apple and Starbucks, which they may use to make dividend payments or share buybacks. These actions can reduce their levels of cash, current assets, and total assets, making their solvency metrics less indicative. Therefore, it's essential to study the solvency of these companies on a case-by-case basis, taking into account their unique financial circumstances.