What are Solvency Ratios?
Solvency Ratios are the ratios that are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate 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.
- Accordingly, Solvency ratios are calculated for judging the financial position to ascertain whether the business is financially sound to meet its long-term commitments.
- Solvency Ratios analyzes the ability of a business to pay its long-term debt. It is important to note here that the portion of Shareholder’s Funds (Owner’s Equity) out of the total liabilities determines the Solvency of an Organization.
- The higher the Shareholder’s Funds compared to other liabilities of the Organization, the greater the Solvency business enjoys and vice versa.
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For eg:
Source: Solvency Ratios (wallstreetmojo.com)
List of Solvency Ratios
A list of important Solvency ratios are discussed below, followed by a Numerical example:
#1 – Long-Term Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of long-term debt business has undertaken vis-à-vis the Equity and helps in finding the leverage of the business. Here Long-Term DebtLong-Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more 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 EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more. The Ratio also helps in identifying how much Long-term debt business has raise compared to its Equity Contribution.
Solvency Ratio Formula:
#2 – Total Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of total debt (which includes both short-term debt and long-term debt) a business has undertaken vis-à-vis the Equity and helps in finding the total leverage of the business. The Ratio helps in identifying how much business is funded by debt compared to Equity Contribution. In a nutshell higher, the ratio, higher the leverage, and higher is the risk on account of a heavy debt obligation (in the form of Interest and Principal Payments) on the part of the business
Solvency Ratio Formula:
#3 – Debt Ratio
This Ratio aims to determine the proportion of total assets of the company (which includes both Current AssetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and Non-Current AssetsNon-Current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more), which are financed by Debt and helps in assessing the total leverage of the business. The higher the ratio, the higher the leverage and higher is the financial risk on account of a heavy debt obligation (in the form of Interest and Principal PaymentsPrincipal PaymentsThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more) on the part of the business
Solvency Ratio Formula:
#4 – Financial Leverage
The Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more ratio captures the impact of all obligation, both interest-bearing and non-interest bearing. This Ratio aims to determine how much of the business assets belong to the Shareholders of the company rather than the Debt holders /Creditors. Accordingly, if the majority of the assets are funded by Equity Shareholders, the business will be less leveraged compared to the majority of the assets funded by Debt (in that case, the business will be more leveraged). The higher the ratio, the higher the leverage and higher is the financial risk on account of heavy debt obligation taken to finance the assets of the business
Solvency Ratio Formula:
#5 – Proprietary Ratio
This ratio establishes the relationship between Shareholders’ funds and total assets of the business. It indicates the extent to which shareholder’s funds have been invested in the assets of the business. The higher the ratio, the lesser the leverage, and comparatively less is the financial riskFinancial RiskFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more on the part of the business. Conversely, it can be calculated by taking the inverse of the Financial Leverage Ratio.
Solvency Ratio Formula:
Example of Solvency Ratios
Let’s understand the above Ratios with the help of a Numerical example for better conceptual clarity:
Alpha and Beta are two companies operating in the same line of business of Leather Shoe Manufacturing, which has furnished certain details from their Balance Sheet at the end of the year. Let’s analyze the Solvency of the two businesses based on the same.
| Particulars | Alpha Company | Beta Company |
|---|---|---|
| Common Stock (1$ par value) (1) | $550000 | $500000 |
| Preferred Stock (2) | $150000 | $200000 |
| Retained Earnings (3) | $800000 | $700000 |
| Total Equity (1+2+3) | $1500000 | $1400000 |
| Current Assets (A) | $1500000 | $1700000 |
| Long Term Assets/ Non Current Assets (B) | $1500000 | $1200000 |
| Total Assets (A+B) | $3000000 | $2900000 |
| Short Term Debt (C) | $600000 | $1000000 |
| Long Term Debt (D) | $900000 | $500000 |
| Total Debt (C+D) | $1500000 | $1500000 |
Now, let’s see the formula and calculation for the Solvency Ratios below:
In the below-given figure, we have done the calculation for various solvency ratios.
| Ratios | Alpha Company | Beta Company |
|---|---|---|
| Long Term Debt to Equity Ratio | Long Term Debt/Total Equity =$900000/$1500000 =0.6 | Long Term Debt/Total Equity =$500000/$1400000 =0.36 |
| Total Debt to Equity Ratio | Total Debt/Total Equity =$1500000/$1500000 =1 | Total Debt/Total Equity =$1500000/$1400000 =1.07 |
| Debt Ratio | Total Debt/Total Assets =$1500000/$3000000 =0.5 | Total Debt/Total Assets =$1500000/$2900000 =0.52 |
| Financial Leverage | Total Assets/Total Equity =$3000000/$1500000 =2 | Total Assets/Total Equity =$2900000/$1400000 =2.07 |
| Proprietary Ratio | Total Equity/Total Assets =$1500000/$3000000 =0.5 | Total Equity/Total Assets =$1400000/$2900000 =0.48 |
Based on the above Ratios, we can observe a few interesting insights:
- Alpha Company has a higher Long-Term Debt to Equity Ratio compared to Beta Company but a lower Total Debt to Equity ratio compared to Beta, which is an indication that Beta Company is using more short-term debt financing to fund itself and will be more prone to liquidity risks in case the short-term rates moved adversely.
- Both the companies are having the same level of Total Debt; however, due to increase equity Contribution, Alpha Company has less financial Leverage compared to Beta Company.
Conclusion
It must be noted that the various Solvency Ratios discussed above should not be seen in isolation but should be considered collectively, which will help stakeholders better understand and appreciate the importance of these ratios and make a better judgment related to the long-term solvency and ability of the business to honor its financial commitments and continue being a value creator.
Solvency Ratios Video
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