solvency ratio

Reviewed by Vishnava | Updated on Aug 30, 2021

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Introduction to Solvency Ratio

A solvency ratio is a vital metric used to see a business's ability to fulfil long-term debt requirements and is used by prospective business lenders. It shows whether a company's cash flow is good enough to meet its long-term liabilities. It is, therefore, considered to a measure of its financial health. An unfavourable ratio can show some likelihood that a company will default on its debt obligations.

The principal solvency ratios are the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio. These measures can be compared with liquidity ratios, which consider a firm's capability to meet short-term obligations rather than medium- to long-term ones.

Understanding Solvency Ratios

Solvency ratios are one of many metrics applied to determine whether a company can stay solvent in the long term.

A solvency ratio is a general measure of solvency, as it measures a firm's actual cash flow, rather than net income, by adding depreciation and other non-cash expenses to evaluate a company's capacity to stay afloat.

It estimates this cash flow capacity in relation to all liabilities. This way, a solvency ratio estimates a company's long-term health by evaluating its repayment ability for its long term debt and the interest on that debt.

Types Of Solvency Ratios

  • Debt to equity ratio - Debt to equity is known to be one of the most used debt solvency ratios. It is also described as the D/E ratio. The debt to equity ratio is usually determined by dividing a company's total liabilities with the shareholder's equity—these company's obtained from the balance shareholder's company's financial statements.

  • Debt Ratio - A debt ratio is a financial ratio used in estimating a company's financial leverage. It is determined by taking the total liabilities and dividing them by total capital. If the debt ratio is higher, it signifies that the company is riskier. The long-term debts involve bank loans, bonds payable, notes payable etc.

  • Proprietary Ratio Or Equity Ratio - Proprietary ratios are also known as equity ratio. It builds a relationship between the proprietor's funds and the net assets or capital.

  • Interest Coverage Ratio - The interest coverage ratio is applied to determine whether the company is able to pay interest on the outstanding debt obligations. It is evaluated by dividing the company's EBIT (Earnings before interest and taxes) with the interest payment due on debts for the accounting period.

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