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 a 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.
Types of Solvency Ratios
Solvency ratio is calculated from the components of the balance sheet and income statement elements. Solvency ratios help in determining whether the organisation is able to repay its long term debt. It is very important for the investors to know about this ratio as it helps in knowing about the solvency of a company or an organisation.
Let us see in detail about the various types of 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 shareholder’s 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 = Long term debt / shareholder’s funds
Debt to equity ratio = total liabilities / 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 Ratio
Debt 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 ratio is higher, it represents the company is riskier.
The long-term debts include bank loans, bonds payable, notes payable etc.
Debt ratio is represented as
Debt Ratio = Long Term Debt / Capital or Debt Ratio = Long Term Debt / Net Assets
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. Proprietary Ratio or Equity Ratio
Proprietary ratios is also known as equity ratio. It establishes a relationship between the proprietors funds and the net assets or capital.
It is expressed as
Equity Ratio = Shareholder’s funds / Capital or Shareholder’s funds / Total Assets
4. 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 on long term debt
Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.
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.