Introduction to Solvency Ratios

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Financial Ratios:
Introduction to
Solvency Ratios

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Importance of Solvency Ratios
• A key metric used to measure an enterprise’s ability to meet its debt and other
obligations.
• The solvency ratio indicates whether a company’s cash flow is sufficient to meet its
short-term and long term liabilities.
• A solvent company is the one that owns more than it owes, in other words it has a
positive net worth and a manageable debt load.
• Solvency and liquidity are equally important and healthy companies are both solvent
and possess adequate liquidity.
• A company’s solvency ratio should also be compared with its competitors in the same
industry rather than viewed in isolation.
• Eg: Companies in debt heavy industries like utilities may have lower solvency ratios
than those in sectors such as technology.

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Solvency Ratios : Debt-Equity Ratio
Debt-Equity Ratio = Long –term debts
Share holder’s fund
Normally it is considered to be safe if debt equity ratio is 2:1
It can vary from industry to industry.
From security point of view capital structure with less debt and more equity is considered favourable as it
reduces chances of bankruptcy.
Debt – Equity ratio measures the relationship between long term debt and equity.
If debt component of the total long term funds employed is small, outsiders feel more secure.

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Solvency Ratios : Debt-to-Capital Employed Ratio
Like debt –to equity ratio it shows proportion of long term debts in capital employed.
Low ratio provides security to lenders and high ratio helps management in trading on equity.
Capital employed is equal to long term debt + shareholder’s fund.
It is computed as follows: Debt to capital employed ratio = Long term debt
Capital Employed (or Net assets)
Debt to capital employed ratio refers to the ratio of long term debt to the total of external and internal
funds (capital employed or net assets).

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Solvency Ratios : Proprietary Ratio
It may be noted that the total of debt to capital employed and proprietary ratio is equal to 1.
Higher proportion of shareholder’s fund in financing the assets is a positive feature as it provides security
to creditors.
It is calculated as follows: Proprietary ratio = Shareholder’s fund
Capital employed (or net assets)
Proprietary ratio expresses relationship between proprietor’s (shareholder’s fund) to net assets.

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Solvency Ratios : Total Assets to debt Ratio
It is better to take the net assets (capital employed) instead of total assets for computing this ratio.
This ratio is the reciprocal of the debt to capital employed ratio.
The higher ratio indicates that assets have been mainly financed by owner funds and the long term loans
is adequately covered by assets.
It is calculated as follows: Total assets to debt ratio = Total Assets
Long term debts
This ratio measures the extent of coverage of long term debts by assets.

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Solvency Ratios : Interest Coverage Ratio
It reveals the number of times interest on long term debts is covered by the profits available for interest.
It is a measure of security of interest payable on long term debts.
It expresses the relationship between profits available for payment of interest and the amount of interest
payable.
Interest Coverage ratio = Net profit before Interest and Tax
Interest on long term debts
It is the ratio which deals with the servicing of interest on a loan.

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