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In: Accounting

what is solvency ratio? why would a financial institution or investor use this ratio? what would...

what is solvency ratio? why would a financial institution or investor use this ratio? what would the ratio results tell you about this business?

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Expert Solution

S.No Particulars
1 The solvency ratio is used to measure an Organisation’s ability to meet its debt obligations. The solvency ratio indicates whether a Organisation’s cash flow is sufficient to meet its short-and long-term liabilities.
2 The solvency ratio is calculated by dividing a organisation's after-tax net operating income by its total debt obligations. The net after-tax income is derived by adding non-cash expenses, such as depreciation and amortization, back to net income. these figures come from the organisation's income statement. Short-term and long-term liabilities are found on the organisation's balance sheet.
3

As a general rule of thumb, a solvency ratio higher than 20% is considered to be financially sound; however, solvency ratios vary from industry to industry. A organisation’s solvency ratio should, therefore, be compared with its competitors in the same industry rather than viewed in isolation.

Example :-

Particulars Co. A Co. B
Net Income $5,000 $5,000
Depreciation $3,500 $3,500
Net Income + Depreciation (A) $8,500 $8,500
Short-Term Debt $14,000 $20,000
Long-Term Debt $14,500 $25,000
ST Debt + LT Debt (B) $28,500 $45,000
Solvency Ratio = (A)/(B) 29.82% 18.89%

Comment :- Co. A has Better Solvency Ratio Than Co. B.


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