Solvency Ratio and Its Types

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When it comes to investing in a company, solvency is a crucial aspect. It is necessary to determine company's ability to pay its debt obligations.

Read on for a breakdown of what solvency ratios are, why are they important, various types of profitability ratio, and how to calculate them.


What is Solvency Ratio?

Solvency ratios are also known as leverage ratios which  helps us examine a company’s financial health. It helps us in determining whether a company has sufficient cash flow to manage the debt obligations that are due. Do not mix solvency ratios 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.

 

Why are solvency ratios important?

All the funds required to run the business are not acquired from owners. Many businesses take debt in form of bonds, debentures, and loan. In long term, all the debts need to be repaid along with interest. Therefore, before investing in a stock it is necessary to consider long term solvency of the company. Solvency ratios helps us to indicate long term solvency of the business.

 

Types of Solvency Ratio

Debt to Equity Ratio

Debt to Equity ratio is often abbreviated as D/E ratio. It is an important metric which is used to evaluate a company’s financial leverage. The higher the debt, more leveraged is the company This ratio helps understand if the shareholder’s equity can cover all the debts in case business is experiencing a rough time. It establishes a company’s total debts relative to its equity. 


D/E ratio greater than 1 indicates that the company has more debt on its balance sheet than shareholders equity. The higher the ratio, more debt the company has on its book meaning higher chance of default. The ideal D/E ratio varies from industry to industry depending upon the industry structure, but it should not be more than 2. It is preferable to choose a company with lower debt as during recession highly leveraged company are more likely to default on its interest payment.

 

Interest Coverage Ratio

Interest coverage ratio is used to determine how easily a company can pay interest on its outstanding debt. With this ratio we can measures how many times a company can cover its current interest payment with its available earnings.

Interest coverage ratio of greater than 1 indicates that current earnings are sufficient to pay off current interest obligation. A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.

 

Debt Ratio

Debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is used to determines the proportion of a business’ total capital that is financed using debt. It should be noted that debt here includes both long-term and short-term debt.

Debt ratio of 0.4 indicates that 40% of the company’s assets are finance through debt and rest 60% is financed through owners’ fund. A company with a high degree of leverage may find it more difficult to stay afloat during a recession than one with low leverage. Thus, a lower ratio is preferred, as it implies that the company can pay for capital without relying so much on debt.

 

Proprietary Ratio /Equity Ratio

Proprietary ratio is used to determines the proportion of a business’ total capital that is financed using shareholder’s fund. It establishes a relationship between the proprietor’s funds and the net assets or capital. The ratio is an indicator of how financially stable the company may be in the long run.

Proprietary ratio of 0.8 indicates that 80% of the company’s assets are financed through owner’s fund and rest 20% through debt. The higher the ratio, better it is for the company as it means that the company has financed majority of its assets with equity capital instead of taking on debt. 

 

Example 


D/E Ratio = 2174/19802

                   = 0.11

Interest Coverage Ratio = 4932/25

                                           = 197

Debt Ratio = 10209/30011

                    = 0.34

Proprietary Ratio = 19802/30011

                               = 0.66


Final Words:

Solvency ratio helps to determine the solvency of the business organization by measuring its ability to pay long-term debt obligation. Remember, solvency ratios are not the only ratios that you should track. Look for liquidity ratios, turnover ratios, valuation ratios and profitability ratios as well and do your exhaustive research  before investing.

Happy Investing!



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