Meaning

Solvency ratios are calculated to determine the ability of the business to meet its liabilities in the long run. Following are the main ratios computed for evaluating solvency of the business.

1. Debt equity ratio.

2. Debt ratio.

3. Proprietary ratio.

4. Total Assets to Debt Ratio.

5. Interest Coverage Ratio.

 

1. Debt-Equity Ratio

Debt Equity Ratio measures the relationship between long-term debt and equity.

From security point of view, capital structure with less debt and more equity is considered favorable as it reduces the chances of bankruptcy.

Debt-Equity ratio = Debt/Equity

Debt =Long Term Borrowings + Long Term Provisions

Equity / Shareholder’s Funds = Share Capital + Reserves and Surplus

or

Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current Trade Investments + Long-Term Loans & Advances) + Working Capital – Non-Current Liabilities (Long-Term Borrowings + Long-Term Provisions) Where Working Capital = Current Assets – Current Liabilities

Significance:

This ratio gives an idea regarding extent of security of the debt. Standard for this ratio is 2:1. A low debt equity ratio reflects more security.

A high ratio is considered risky as it reflects difficulty in meeting obligations towards outsiders. From the owners’ point of view, greater use of debt may help in ensuring higher returns for them if the rate of earnings on capital employed is higher than the rate of interest payable (benefit of trading on equity can be taken). This, ratio is also known as ‘Leverage Ratio’.

 

2. Debt Ratio (Debt to total funds ratio)

The Debt Ratio is the ratio of long-term debt to the total of external and Internal funds (capital employed or net assets).

Debt Ratio (Debt to total funds ratio) = Long-term Debt/Capital Employed

1. Capital employed = long-term debt + shareholders’ fund.

2. Capital Employed=Net assets (Total assets – current liabilities-fictitious assets).

Significance:

It shows proportion of long-term debt in capital employed. Low ratio provides security to creditors and high ratio helps management in trading on equity.

 

3. Proprietary Ratio

Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets.

Proprietary Ratio = Shareholders Funds/Capital employed (or net assets)

Proprietors Funds = Share Capital + Reserves and Surplus

or

Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current Trade Investments + Long-Term Loans & Advances) + Working Capital – Non-Current Liabilities (Long-Term Borrowings + Long-Term Provisions)

Total Assets = Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current Investments + Long-Term Loans & Advances) + Current Assets (Current Investments + Inventories excluding Spare Parts & Lose Tools + Trade Receivables + Cash & Cash Equivalent + Short-Term Loans & Advances +Other Current Assets).

Significance:

Higher ratio provides security to creditors.

Debt Ratio +Proprietary Ratio = 1.

 

4. Total Assets to Debt Ratio

This ratio measures the extent of the coverage of long-term debt by assets.

Total assets to Debt Ratio = Total Net assets/Long-term debt

Total Assets = Non-Current Assets (Tangible Assets + Intangible Assets + Non-Current Investments + Long-Term Loans & Advances)+ Current Assets (Current Investments + Inventories including Spare Parts & Lose Tools + Trade Receivables + Cash & Cash Equivalent + Short-Term Loans & Advances + Other Current Assets).

Debt =Long Term Borrowings + Long Term Provisions

Significance:

This ratio primarily indicates the rate of external funds in financing the assets. The higher ratio indicates that assets have been mainly financed by owners’ funds, and the long-term debt is adequately covered by assets.

 

5. Interest Coverage Ratio:

This ratio establishes relationship between the net profits before interest & tax(PBIT) and interest payable on long term debts.

Interest Coverage Ratio = Net Profit before Interest & Tax/Total Interest charges

Significance:

It helps to ascertain the amount of profit available to cover the interest charge and how easily a company can pay interest expense on outstanding debt.

High Ratio is better for lenders as it indicates higher safety margin.

Check for More Posts in This Category