Solvency ratio

Owning assets is not the same as being solvent. The workbook puts it bluntly: despite having assets, a person may be insolvent if the liabilities are higher than the value of the assets held.

The critical benchmark is simply that net worth should be positive. The solvency ratio goes one step further and measures the extent of solvency — what proportion of the assets on the balance sheet belongs to the household rather than to its lenders.

For the same asset position, higher the solvency ratio, stronger the investor's financial position. A household with Rs 65 lakh of assets and an 80% solvency ratio owns Rs 52 lakh of them outright; one with a 20% ratio owns Rs 13 lakh and owes the rest.

The ratio is built from two numbers already on the personal balance sheet.

Net worth = Total assets − Total liabilities. The workbook monitors a client's position through net worth, tracked over time for improvement or deterioration.

Solvency ratio = Net worth ÷ Total assets.

In the workbook's running example — assets of Rs 65 lakh (real estate Rs 50 lakh, investments and bank balances Rs 10 lakh, provident fund Rs 5 lakh) and liabilities of Rs 13 lakh — net worth is Rs 52 lakh and the solvency ratio is 52 ÷ 65 = 80%.

Because net worth is assets minus liabilities, the ratio is exactly one minus the leverage ratio: Solvency ratio = 1 − Leverage ratio, and Leverage ratio = 1 − Solvency ratio. The workbook states both directions. With leverage at 13 ÷ 65 = 20%, solvency is 80%.

The workbook also warns against reading a liability as bad in itself: a liability used to create an asset with the potential to appreciate, such as real estate, is not bad. What matters is the relationship between the two sides.

Net worth      = Total assets − Total liabilities
Solvency ratio = Net worth ÷ Total assets
               = 1 − Leverage ratio

Illustrative figures.

Two clients each hold Rs 40,00,000 of assets.

Identical asset totals, opposite conclusions. Ms Kulkarni owns more than three-quarters of what she holds. Mr Bhatt fails the workbook's critical benchmark — his net worth is negative — so he is insolvent even though he "has" Rs 40 lakh of assets. His leverage ratio above 1 says the same thing from the other side: his assets would not be adequate to meet his liabilities.

Check the identity on both: 78.75% + 21.25% = 100%, and −10% + 110% = 100%.

For Mr Bhatt the adviser's work begins with the liabilities, costliest first — the Rs 5 lakh of card dues and the personal loan — not with a new investment product.

Chapter 3 (Cash Flow Management and Budgeting), section 3.9.6, directly after net worth at 3.9.5 and the leverage ratio at 3.9.4. The paper tests the formula, the 1 − leverage identity, and the idea that a person can be insolvent while holding substantial assets.

• The denominator is total assets, not total liabilities. Net worth ÷ liabilities is not a ratio the workbook uses.
• Solvency + leverage = 100%. Given leverage of 20%, solvency is 80% without any further data.
• Holding assets does not make a person solvent. The benchmark is positive net worth.
• For the same asset position, higher is better. Comparing ratios across very different asset bases needs care.
• A liability is not bad in itself — the workbook says a loan that creates an appreciating asset is not bad. The ratio judges the balance, not the existence of debt.
• Net worth, not total assets, is the number to track. The workbook notes that individuals tend to look at total assets, but it is net worth that is more relevant.