Question

what are solvency ratios?

Answer 1

Solvency ratios also known as leverage ratios determine an entity’s ability to service its debt. So these ratios calculate if the company can meet its long-term debt. It is important since the investors would like to know about the solvency of the firm to meet their interest payments and to ensure that their investments are safe.

1] Debt to Equity Ratio

The debt to equity ratio measures the relationship between long-term debt of a firm and its total equity. Since both these figures are obtained from the balance sheet itself, this is a balance sheet ratio. Let us take a look at the formula.

Debt to Equity Ratio = Long-Term Debt/Shareholders Funds

Long Term Debt = Debentures + Long Term Loans

Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves - Fictitious Assets

The debt-equity ratio holds a lot of significance. Firstly it is a great way for the company to measure its leverage or indebtedness. A low ratio means the firm is more financially secure, but it also means that the equity is diluted.

2] Debt Ratio

This ratio measures the long-term debt of a firm in comparison to its total capital employed. Alternatively, instead of capital employed, we can use net fixed assets. So the debt ratio will measure the liabilities (long-term) of a firm as a percent of its long-term assets. The formula is as follows,

Debt Ratio = Long-Term Debt/Capital Employed OR Long-Term Debt/Net Assets

Capital Employed = Long Term Debt + Shareholders Funds

Net Assets = Non-Fictitious Assets - Current Liabilities

A low ratio points to a more financially stable business, better for the creditors. A higher ratio points to doubts about the firms long-term financial stability.

3] Proprietary Ratio

The third of the solvency ratios is the proprietary ratio or equity ratio. It expresses the relationship between the proprietor’s funds, i.e. the funds of all the shareholders and the capital employed or the net assets. Like the debt ratio shows us the comparison between debt and capital, this ratio shows the comparison between owners funds and total capital or net assets. The ratio is as follows,

Proprietary Ratio = Shareholders Funds/Capital Employed OR Shareholders Funds/Net Assets

A high ratio is a good indication of the financial health of the firm. It means that a larger portion of the total capital comes from equity.

4] Interest Coverage Ratio

All debt has a cost, which we normally term as an interest. Debentures, loans, deposits etc all have an interest cost. This ratio will measure the security of this interest payable on long-term debt. It is the ratio between the profits of a firm available and the interest payable on debt instruments. The formula is,

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term Debt