Solvency refers to the company’s ability to meet all of its obligations and to pay all of its liabilities when they are due to be paid. Solvency ratios are used to check the solvency condition of a company which mainly checks for the amount of debt taken and the cash spent on interest of the total debt taken.
We know from the balance sheet,
Total Assets = Total Debts + Total Equity
The debt ratio calculates the total debt compared to total assets and Debt-Equity ratio calculates the total debt to its total equity capital.
Debt Ratio = (Total Debt / Total Assets)
Debt-Equity Ratio = Total Debt / Total Shareholders’ Equity
Higher debt ratio means the company has already taken higher debts from the market and the main funding came from outside. Higher debt ratio reduces the capability of the company to raise more debt in the future and the creditors feel less confident in giving further debt to the company.
Higher debt to equity ratio also indicates that a significant amount of money came from external debts and company is paying very high interest for the same. It also makes it difficult for the company to raise more money from the market.
But as debt is considered to be much cheaper source of fund compared to equity capital, Company’s management is encouraged to use debt source of fund properly to reduce the average cost of capital. So management has to divide the fund raised between debt and equity properly so that cost of capital is reduced and the debt-equity ratio stays within proper limit. Higher debt-equity ratio leads to higher borrowing cost from debt or higher rate of interest.
Debt-Equity ratio is also used to check the financial leverage position of the company which means how much company financial leverage the company is utilizing. Lower debt-equity ratio means lower financial leverage taken by the company and the company has high equity position.
It’s completely the creditability of the company’s management to use the debt capital and financial leverage properly to keep the cost of capital lower and to earn high profit even after paying the interest.
Another important solvency ratio is capitalization ratio which denotes the capitalization or the debt part of the company to run the business. The capitalization refers to the use of debt as financial leverage to run the business and generate profit.
The capitalization ratio is calculated as the long term debt divided by the sum of long term debt and shareholders’ equity.
Capitalization Ratio = Long term Debt / (Long term Debt +
The Capitalization ratio shows how much the company capitalizes the external debt and it also shows the management’s efficiency towards the same.
The Interest Coverage Ratio is another very important solvency ratio which determines the company’s ability to pay the interest on outstanding loan and debt from the operating profit earned by the company. It is calculated as
Interest Coverage Ratio = Earnings before Interest and
Taxes (EBIT) / Interest Expenses
Lower interest coverage ratio means more burden to the company to pay the interest and less profit for the company and the shareholders. The creditors check this ratio more frequently to keep track of the solvency condition of the condition. Interest coverage ration becoming nearly 1 means it is an alarming situation for the company.