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Solvency Ratios

Updated on May 14, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What are Solvency Ratios?

Solvency Ratios are the ratios calculated to judge the organization’s financial position from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations. Investors closely track them to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision-making for the long-term investment of their funds in the business.

  • Accordingly, Solvency ratios are calculated to judge the financial position to ascertain whether the business is financially sound enough to meet its long-term commitments.
  • Solvency Ratios analyze 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.

Key Takeaways

  • Solvency ratios reflect a company’s financial standing for the long term. Investors use them to assess the company’s ability to handle debt and make informed investment decisions.
  • The purpose of the calculation is to assess the financial status of a company and ascertain whether it possesses sufficient resources to meet its long-term commitments.
  • To assess financial stability, consider important solvency ratios like long-term debt-to-equity, total debt-to-equity, debt, financial leverage, and proprietary ratios. Owner’s equity compared to total liabilities also impacts stability.
What are Solvency Ratios

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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 a business has undertaken vis-à-vis the Equity and helps find the business’s leverage. The Ratio also helps identify how much Long-term debt a business has to raise compared to its Equity Contribution. 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.

Solvency Ratio Formula:

Long Term Debt to Equity Ratio= Long Term Debt/ Total Equity

#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 find the total leverage of the business. The Ratio helps identify how much business is funded by debt compared to Equity Contribution. In a nutshell, the higher the ratio, the higher the leverage, and the 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:

Total Debt to Equity Ratio= Total Debt/ Total Equity

#3 – Debt Ratio

This Ratio aims to determine the proportion of the company’s total assets (which includes both Current Assets and Non-Current Assets) financed by Debt. It 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 Payments) on the part of the business.

Solvency Ratio Formula:

Debt Ratio= Total Debt/ Total Assets

#4 – Financial Leverage

The Financial Leverage ratio captures the impact of all obligations, 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 Equity Shareholders fund the majority of the assets, the business will be less leveraged than 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 the higher the financial risk on the heavy debt obligation taken to finance the business’s assets.

Solvency Ratio Formula:

Financial Leverage= Total Assets/ Total Equity

#5 – Proprietary Ratio

This ratio establishes the relationship between Shareholders’ funds and the business’s total assets. It indicates how much shareholder funds have been invested in the business’s assets. The higher the ratio, the lesser the leverage, and comparatively less is the financial risk on the part of the business. Conversely, it can be calculated by taking the inverse of the Financial Leverage Ratio.

Solvency Ratio Formula:

Proprietary Ratio= Total Equity/ Total Assets

Solvency Ratios Explained in Video

 

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.

ParticularsAlpha CompanyBeta 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.

RatiosAlpha CompanyBeta Company
Long Term Debt to Equity RatioLong Term Debt/Total Equity
=$900000/$1500000
=0.6
Long Term Debt/Total Equity
=$500000/$1400000
=0.36
Total Debt to Equity RatioTotal Debt/Total Equity
=$1500000/$1500000
=1
Total Debt/Total Equity
=$1500000/$1400000
=1.07
Debt RatioTotal Debt/Total Assets
=$1500000/$3000000
=0.5
Total Debt/Total Assets
=$1500000/$2900000
=0.52
Financial LeverageTotal Assets/Total Equity
=$3000000/$1500000
=2
Total Assets/Total Equity
=$2900000/$1400000
=2.07
Proprietary RatioTotal 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 than Beta Company. Still, a lower Total Debt to Equity ratio compared to Beta 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 move adversely.
  • Both the companies have the same level of Total Debt; however, due to increased equity Contribution, Alpha Company has less financial Leverage than 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.

Frequently Asked Questions (FAQs)

What are short-term solvency ratios?

Short-term solvency ratios determine if a company has enough liquid assets to meet short-term obligations. These ratios include the current, acid test, inventory, and accounts receivable turnover ratios.

What are good solvency ratios?

Solvency ratios differ depending on the industry, but a solvency ratio of 0.5 is generally a good benchmark to aim for.

Why solvency ratios are essential?

One way to evaluate a company’s financial stability is by calculating its solvency ratio. This ratio examines whether a company’s cash flow is sufficient to pay its long-term debt. It is a crucial metric for assessing a company’s financial well-being and predicting the possibility of defaulting on its debts.

How often should solvency ratios be analyzed?

The frequency of analyzing solvency ratios depends on the company’s specific circumstances and reporting requirements. Large corporations often review solvency ratios quarterly or annually in their financial reporting and planning processes. Smaller businesses may do so less frequently but should monitor their solvency regularly to ensure financial health.

This article has been a guide to What is Solvency Ratios. Here we discuss the list of Solvency Ratio formulas, their calculations, along with practical examples. You may also have a look at some useful articles below –

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