Long Term Liquidity Ratios/ Solvency Ratios

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.

Accounting & Finance for Banking

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