Key Takeaways
- The capital adequacy ratio (CAR) assesses if a bank has enough capital to handle potential losses.
- Regulators use CAR to ensure banks maintain efficient and stable financial systems.
- A solvency ratio evaluates any company's ability to meet its short- and long-term debts.
- Solvency ratios below 20% indicate a higher risk of default.
- Comparing solvency ratios within the same industry provides better insights due to varying debt levels.
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.