Sat. Aug 13th, 2022

    Solvency Ratio

    A solvency ratio is a performance metric that helps us examine a company’s financial health. In particular, it enables us to determine whether the company can meet its financial obligations in the long term.

    Formula Solvency Ratio

    Solvency Ratio = (Net Income + Depreciation) / All Liabilities (Short-term + Long-term Liabilities)

    Solvency and liquidity are both terms that refer to an enterprise’s state of financial health, but with some notable differences.

    Solvency refers to an enterprise’s capacity to meet its long-term financial commitments. Liquidity refers to an enterprise’s ability to pay short-term obligations—the term also refers to a company’s capability to sell assets quickly to raise cash.

    Other Solvency Ratios

    1. Total Debt to Equity Ratio = Total Debt / Total Equity

    Often abbreviated as D/E, the debt-to-equity ratio establishes a company’s total debts relative to its equity. To calculate the ratio, first, get the sum of its debts. Divide the outcome by the company’s total equity.  This is used to measure the degree to which a company is using debt to fund operations (leverage).

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

    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 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. The Ratio also helps in identifying how much Long-term debt business has raise compared to its Equity Contribution.

    3. Interest Coverage Ratio = Interest Expense / EBIT

    where: EBIT=Earnings before interest and taxes

    It measures how many times a company can cover its current interest payment with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period. The interest coverage ratio is used to determine how easily a company can pay its interest expenses on outstanding debt.​

    With the interest coverage ratio, we can determine the number of times that a company’s profits can be used to pay interest charges on its debts. To calculate the figure, divide the company’s profits (before subtracting any interests and taxes) by its interest payments.

    The higher the value, the more solvent the company. In other words, it means the day-to-day operations are yielding enough profit to meet its interest payments.

    4. Debt-to-Capital Ratio = Debt / (Debt + Shareholder’s equity)

    It determines the proportion of a business’  total capital that is financed using debt. For example, if a company’s debt-to-capital ratio is 0.45, it means 45% of its capital comes from debt. In such a case, a lower ratio is preferred, as it implies that the company can pay for capital without relying so much on debt.

    gives analysts and investors a better idea of a company’s financial structure and whether or not the company is a suitable investment. All else being equal, the higher the debt-to-capital ratio, the riskier the company. This is because a higher ratio, the more the company is funded by debt than equity, which means a higher liability to repay the debt and a greater risk of forfeiture on the loan if the debt cannot be paid timely.

    However, while a specific amount of debt may be crippling for one company, the same amount could barely affect another. Thus, using total capital gives a more accurate picture of the company’s health because it frames debt as a percentage of capital rather than as a dollar amount.

    5. Proprietary Ratio= Total Equity / Total Assets

    This property 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 risk on the part of the business. Conversely, it can be calculated by taking the inverse of the Financial Leverage Ratio.

    6. Financial Leverage= Total Assets / Total Equity

    The Financial Leverage 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.

    Financial Ratio | Accounting - Formulas, Examples, Questions, Answers
    Financial Ratio: Profitability Ratio, Liquidity Ratio, Solvency Ratio, Activity Ratio (Efficiency Ratio), Leverage Ratio, Market Value Ratio, Valuation Ratio and Growth Ratios

    Examples, Questions and Answers for Solvency Ratio

    Let’s look at the case of Hello Candy Co.:

    Hello Candy (USD in millions)
    Net Income45,000
    Depreciation15,000
    Short-term Liabilities83,000
    Long-term Liabilities160,000

    Solvency Ratio = (45,000 + 15,000) / (83,000 + 160,000)

    Solvency Ratio = 0.246 * 100 = 24.6%

    Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%. So, from our example above, it is clear that if Hello Candy Co. keeps up with the trend each year, it can repay all its debts within four years (100% / 24.6% = Approximately 4 years).

    2. Calculate Interest Coverage ratio from the following details

    1. NPAT is 97,500

    2. Tax Rate is 35%

    3. Debentures are 6,00,000 at 10%

    Solution:

    NPAT = 1,25,000
    Tax Rate = 35%
    Net Profit before tax = (97500 × 100) ÷ 65
    Net Profit Before tax = 1,50,000
    Debentures Interest = 6,00,000 × 10% = 60,000

    Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on Long-Term Debt
    = 150 000 / 30 000
    Interest Coverage Ratio = 2.5:1

    So in the current earnings before interest and tax, the firm can cover the interest cost for 2.5 times.

    3. From the following information, calculate current ratio.

    Trade receivables (debtors)1, 00,000Bills payable20,000
    Prepaid Expenses10,000Sundry Creditors40,000
    Cash and cash equivalents30,000Debentures2,00,000
    Short term investments20,000Inventories40,000
    Machinery7,000Expenses Payable40,000

    Solution:

    Current Ratio = Current Assets / Current Liabilities = 2, 00,000 / 1, 00,000 = 2 : 1
    Current Assets = Trade Receivables (sundry Debtors) + prepaid Expenses + cash and cash Equivalents + short term Investments + inventories
    = 1,00,000 + 10,000 + 30,000 + 20,000 + 40,000 = 2,00,000
    Current Liabilities: trade payables (Bills Payable + sundry creditors) + expenses payable
    = 20,000 + 40,000 + 40,000 = 1, 00,000

    4. From the following information, calculate inventory turnover ratio:

    Inventory in the beginning = 18,000
    Inventory at the end = 22,000
    Net purchases = 46,000
    Wages = 14,000
    Revenue from operations = 80,000
    Carriage inwards = 4,000

    Solution:

    Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory
    Cost of Revenue from Operations = Inventory in the beginning + Net Purchases + Wages + Carriage inwards − Inventory at the end
    = 18,000 + Rs. 46,000 + Rs. 14,000 + Rs. 4,000 − Rs. 22,000 = Rs. 60,000
    Average Inventory = Inventory in the beginning + Inventory at the end / 2
    = 18,000 + Rs. 22,000/ 2 = Rs. 20,000
    ∴ Inventory Turnover Ratio = Rs. 60,000/ Rs. 20,000 = 3 Times

    Sources: PinterPandai, Corporate Finance Institute