Capital Adequacy Ratio
The capital adequacy ratio is defined as a measure that helps the company to have sufficient leverage to deal with any potential financial losses. The main purpose of using the capital adequacy ratio is to essentially measure the total financial risk of a company by evaluating the capital available in a bank in relation to the total extended credit.
It also expresses the actual percentage of the total credit exposures of a bank that is weighted by its total risk. It is important to understand that the regulators also track the progress of this ratio for a bank to ensure that it can withstand significant losses or fluctuation in terms of its revenues. The primary function of this ratio is to ensure a stable and efficient financial system. The capital adequacy ratio also helps to measure two types of capital that are differentiated by the tiers. The first tier mainly involves the capital, which can be used for the purpose of absorbing losses without requiring the bank to stop its trading activities. The second tier mainly involves the capital, which can absorb the loss in case the bank is forced to liquidate its assets. The exercise of calculating the capital adequacy ratio adds the total of both the tiers and then that figure is divided by the risk-weighted assets of a company. Investors make use of this ratio to evaluate the capital put by them in different companies.
Solvency Ratio
The solvency ratio is defined as a financial measure that helps to estimate whether a company has enough cash in hand to cover its short term and long term debt needs. The solvency ratio is mainly an accounting ratio that helps to evaluate the debt within an organisation. It can also be applied to any type of company to help them assess their ability to take care of their debt obligations.
Any solvency ratio below a number of 20% is an indicator of a greater likelihood of default, and as such, it can act as a red flag for the company to evaluate their operations and working structure. The analysts also favour the solvency ratio as it helps to provide a comprehensive evaluation of the financial situation of a company. It also helps to measure the actual cash flow of a company rather than their net income, which might not be readily available to meet their 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.
Difference between Capital Adequacy Ratio and Solvency Ratio
Both capital adequacy ratio and solvency ratio have a great amount of importance for any organisation. These accounting ratios can help any investor or analyst to understand if there is a greater probability of a firm becoming insolvent. Potential investors also use these ratios to understand if a company is worth investing in the near or distant future. However, it is also important to understand that there are a number of points of difference between capital adequacy ratio and solvency ratio, and we must discuss them below to get a better understanding of this topic:
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The capital adequacy ratio helps to measure if a company has sufficient leverage to deal with the potential financial losses. |
The solvency ratio helps to measure whether a firm has enough cash in hand to cover its short and long term debts. |
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The main application of the capital adequacy ratio is to evaluate the banks. |
The main application of the solvency ratio is to evaluate other companies. |
Conclusion
Both capital adequacy ratio and solvency ratio have several important uses for any company. They are also used by the investors, analysts and other stakeholders to help evaluate whether an organisation is in any sort of danger in terms of going insolvent in the near or distant future. Although there are a number of points of difference between the capital adequacy ratio and solvency ratio, any organisation needs them both to evaluate their financial position in the overall industry. Using these ratios will also be a big help for the company to sustain its operations while also enabling them to achieve sustainable growth in the long term.
Also See:
- Difference Between Current Ratio and Quick Ratio
- Difference between Fixed Capital Account and Fluctuating Capital Account
- Difference between Comparative Financial Statement and Common Size Financial Statement
- What Is Issue of Debentures for Consideration Other Than Cash
- Change in Profit Sharing Ratio Among the Existing Partners
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