Key Takeaways

Capital Adequacy Ratio vs. Solvency Ratio: An Overview

The capital adequacy ratio and the solvency ratio provide ways to evaluate a company's debt versus its revenues. However, the capital adequacy ratio is usually applied specifically to evaluating banks. It helps evaluate financial risk concerning bank credits. The solvency ratio metric can be used for evaluating any type of company with a focus on evaluating its ability to meet both short-term and long-term obligations.

Both ratios provide insights into a company's financial health, but they serve different purposes. they assist in evaluating potential insolvency, which is crucial for investors and analysts.

The Capital Adequacy Ratio in Banking

Also known as the capital to risk assets ratio, the capital adequacy ratio (CAR) essentially measures the financial risk that examines the available capital of a bank in relation to extended credit. It expresses a percentage of the bank’s credit exposures weighted by risk.

Regulators track the progress of a bank's CAR to ensure that the bank can withstand significant —but not unreasonable—losses or fluctuation in revenues. The ratio's primary function is to effectuate efficient and stable financial systems.

The CAR measures two types of capital differentiated by tiers. The first tier involves capital that can be used to absorb loss without requiring a bank to stop trading. The second tier involves capital that can absorb the loss in the event that the bank is forced to liquidate.1 The calculation for the capital adequacy ratio adds the total of both tiers, and that figure is then divided by the company's risk-weighted assets. As of 2021, the lowest acceptable ratio for a U.S. bank is approximately 8%.2

The Solvency Ratio Across Industries

The solvency ratio is a debt evaluation metric that can be applied to any type of company to assess how well it can cover both its short-term and long-term outstanding financial obligations. Solvency ratios below 20% indicate an increased likelihood of default.

Analysts favor the solvency ratio for providing a comprehensive evaluation of a company's financial situation because it measures actual cash flow rather than net income, not all of which may be readily available to a company to meet obligations. The solvency ratio is best employed in comparison to similar firms within the same industry, as certain industries tend to be significantly more debt-heavy than others.

The Bottom Line

Both the capital adequacy ratio (CAR) and the solvency ratio assess a company's debt relative to its revenues, but they're used in different contexts. The capital adequacy ratio is specific to banks, reflecting their ability to withstand financial losses. The solvency ratio applies to any company, measuring its ability to cover short- and long-term debts with cash. Together, these metrics can help determine the risk of a company becoming insolvent.

KEY TAKEAWAYS

Accounts payable (AP) are often mistaken for a company's core operational expenses, but they appear on a company's balance sheet as current liabilities. They actually represent a company's short-term debts or obligations. These obligations are usually settled within 30 to 60 days.

Reviewing AP helps measure how effectively a company manages its working capital.

What Are Accounts Payable (AP)?

Accounts payable are a liability. More specifically, they are considered short-term liabilities or debts owed to suppliers and/or creditors. Companies often owe these debts for goods and services delivered but not yet paid.

AP are obligations that must be paid within a certain period. Although there is no legal or prescribed time limit, money owed must be paid within a short time—usually within 30, 45, or 60 days. Some companies may offer newer customers a shorter time to pay (or ask for immediate payment) for goods and services while others may offer better customers more time to pay.

Accounts payable appear on a company's balance sheet under the current liabilities section. You can determine how well a company is positioned by analyzing the accounts payable turnover ratio. A high AP turnover ratio means a company earns enough revenue to pay off its short-term debt.

Understanding Liability Accounts vs. Expense Accounts

Liabilities are displayed on a company’s balance sheet, which provides a snapshot of its financial standing. Liabilities are traditionally recorded in the AP sub-ledger at the time an invoice is vouched for payment. Vouched simply means an invoice is approved for payment and has been recorded in the general ledger as an outstanding liability, where the payment transaction is still in the pipeline. Such payables are often referred to as trade payables.

Liability accounts include interest owed on loans from creditors—known as interest payable, as well as any tax obligations accumulated by a company, which are known as taxes payable. These are not part of accounts payable.

Debt owed to creditors typically must be paid within a short time frame—around 30 days or less. These payments don't involve a promissory note. For example, mortgage obligations aren't grouped in with AP because they come with a promissory note attached. This is why mortgage obligations fall under notes payable—none of these are classed as accounts payable.1

Expenses, on the other hand, are displayed on a company’s income statement to convey net income for a given period. An example of an expense transaction would be any cost incurred while a salesperson is attempting to generate revenue on a networking trip. These expenses may include lodging, client dinners, car rentals, gasoline, office supplies, and multimedia materials used for presentations.

Efficiently Tracking Accounts Payable

Keeping track of AP can be a complex and onerous task. For this reason, companies typically employ bookkeepers and accountants who often utilize advanced accounting software to monitor invoices and the flow of outgoing money.

These tracking responsibilities become exponentially more complicated with large firms that have multiple business lines, and with large product manufacturers that produce numerous stock-keeping units (SKUs).

For such entities, bookkeeping personnel are increasingly relying on the use of specialized accounts payable automation solutions (often referred to as ePayables) to simplify processes by automating the paper and manual elements associated with coordinating an organization's invoices.

The Bottom Line

Accounts payable are short-term obligations that companies must pay for unpaid goods and services delivered. These figures are liabilities, which is why they appear on the balance sheet under current liabilities, unlike the expenses they represent. They're commonly found on a company's income statement.