All the funds that are used to run a company are not obtained directly from the owners. To manage business companies usually take debt which can be in the form of deposits, debentures or loans. In the long-term debts that are taken by the business needs to be repaid along with interest.
Solvency is referred to as the firm’s ability to meet its long-term debt obligations.
What is Solvency Ratio?
Solvency ratios are a key component of the financial analysis which helps in determining whether a company has sufficient cash flow to manage the debt obligations that are due. Solvency ratios are also known as leverage ratios. It is believed that if a company has a low solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and is likely to default in debt repayment.
Solvency ratios are used by prospective business lenders to determine the solvency state of a business. Companies that have a higher solvency ratio are deemed more likely to meet the debt obligations while companies with a lower solvency ratio are more likely to pose risk for the banks and creditors. Solvency ratios vary with the type of industry, but as a good measure a solvency ratio of 0.5 is always considered as a good number to have.
Solvency ratios should not be confused with liquidity ratios. They are totally different. Liquidity ratios determine the capability of a business to manage its short-term liabilities while the solvency ratios are used to measure a company’s ability to pay long-term debts.
Solvency Ratio Formula
The solvency ratio formula is as follows:
Solvency ratio = (Net income after tax + non-cash expenses) ÷ All liabilities (Short Term + Long Term Liabilities)
Types of Solvency Ratios
Solvency ratio is calculated from the components of balance sheet and income statement elements. Coverage solvency ratios are based on income statement elements while debt solvency ratios are based on balance sheet items.
Let us see in detail about the various types of debt solvency ratios.
1. Debt to equity ratio
Debt to equity is one of the most used debt solvency ratios. It is also represented as D/E ratio. Debt to equity ratio is calculated by dividing a company’s total liabilities with the shareholder’s equity. These values are obtained from the balance sheet of the company’s financial statements.
It is an important metric which is used to evaluate a company’s financial leverage. This ratio helps understand if the shareholders equity has the ability to cover all the debts in case business is experiencing a rough time.
It is represented as
Debt to equity ratio = total debt / total shareholder’s equity
Debt to equity ratio = total liabilities / total shareholders’ equity
A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the company is using debt for fuelling its growth. It also indicates lower solvency of the business.
2. Debt to Capital Ratio
Debt to capital ratio is a financial ratio that is used in measuring a company’s financial leverage. It is calculated by taking the total liabilities and dividing it by total capital. If the debt to capital ratio is higher it represents the company is riskier.
The long-term debts include bank loans, bonds payable, notes payable etc.
Debt to capital ratio is represented as
Debt-To-Capital Ratio = Total Debts / Total Capital
Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt about a firm’s long-term stability. Trading on equity is possible with a higher ratio of debt to capital which helps generate more income for the shareholders of the company.
3. Total Debt to Total Asset Ratio
Total debt to total asset ratio is a type of debt ratio that defines the total amount of debt to the total assets that are owned by a company. This ratio helps reflect the financial stability of the company. A high ratio indicates high degree of leverage and therefore a high risk for the investors looking to invest in the company.
It shows what part of the assets are financed by debt and what part is financed by equity. Investors use this ratio for whether the company has funds for meeting its current debt obligations and determine whether the company is able to pay a return on the investment done.
It is represented as:
Total Debt/Total Assets Ratio = Short-Term Debt + Long-Term Debt / Total Assets
Creditors make use of this ratio to determine the debt that company has and if additional debts can be provided to the firm.
Now, we will discuss the Coverage Solvency Ratios.
Coverage solvency ratios are ratios which determine the capability of a firm’s cash flows and earnings in order to meet its long-term debt obligations. These ratios are calculated from the income statement items. Following are some of the coverage solvency ratios
1. Interest Coverage Ratio
The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding debt obligations. It is calculated by dividing company’s EBIT (Earnings before interest and taxes) with the interest payment due on debts for the accounting period.
It is represented as
Interest coverage ratio = EBIT / interest payments due on debt
Where EBIT = Earnings before interest and taxes
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.
2. Fixed Charge Coverage Ratio or FCCR
This ratio determines a firm’s ability in paying all the fixed charges which can include equipment lease expense, debt payments and interest expense. It is helpful for lenders such as banks and other financial institutions in evaluating if further money can be provided as a loan to the firm. It is a measure of creditworthiness of the business.
It is calculated as
Fixed charge coverage ratio = EBIT + fixed charges before tax / interest + fixed charges before tax
The higher the coverage ratio the better it is for the firm’s solvency.
This was all about the solvency ratios that determine the solvency of a business organisation by measuring its ability to pay long term debt obligations. It will help the students in developing a good knowledge of the concept of solvency ratios. For more such detailed concepts, stay tuned to BYJU’S.