Solvency refers to the business’ long-term financial position. Solvency ratios are a key component of financial analysis and are used to measure a company’s ability to pay long-term debts.
These ratios help the investors to understand the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business.
Although these ratios vary according to the nature of the industry but a solvency ratio of 0.5 is considered to be an ideal measure.
TYPES OF SOLVENCY RATIOS
The various types of solvency ratios are –
DEBT TO EQUITY RATIO :
The debt to equity ratio is used to measure the firm’s obligations to creditors in relation to the funds invested by owners. It is calculated by dividing a company’s total liabilities with the shareholder’s equity.
Debt to Equity Ratio = Long Term Debt/ Shareholders Funds
Here Long-Term Debt includes long-term loans, i.e., Debentures or Long-term loans taken from Financial Institutions and Equity means Shareholders’ Funds, i.e., Equity Share Capital, Preference Share Capital and Reserves in the form of Retained Earnings.
DEBT RATIO :
Debt ratio is used to measure a company’s financial leverage. It is the ratio of total debt (long-term liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as ‘goodwill’). It is calculated as –
Debt Ratio = Long Term Debt / Total Assets
A low Debt ratio indicates the stable financial position of the business whereas a higher Debt Ratio represents that the company is riskier.
PROPRIETARY RATIO :
Also known as Equity ratio , this ratio establishes the relationship between Shareholders’ funds and total assets of the business. It is calculated as –
Proprietary Ratio = Shareholder’s Funds/ Total Assets
The higher the ratio, the less will be the financial risk on the part of the business.
INTEREST COVERAGE RATIO :
The interest coverage ratio (ICR) is a measure of a company’s ability to meet its interest payments.
It is represented as –
Interest Coverage Ratio = EBIT (Earnings before interest and tax) / Interest on long term debt
A high interest coverage ratio indicates favourable solvency position of the firm whereas a low ratio indicates debt burden on the business.
Thus, the solvency ratios are the ratios that determine the solvency of a business organisation by measuring its ability to pay long term debt obligations and form an important aspect of analysing a company’s long-term financial health and stability.