MEANING
Solvency ratios are financial ratios that measure a company's ability to meet its long-term financial obligations. These ratios are used to evaluate a company's financial stability and its ability to survive over the long term.
Suppose I take a loan of Rs 1 crores from bank to purchase a house. From that money, I purchased a house. Now I do not have any money left. But I have to purchase food, clothes etc. for my daily expenses. Can someone say that, since I have Rs 1 Crores so I don't have any money shortage? No we can't say this. I still need money for my daily needs. This is called short term funds and the Rs 1 crores I loaned from bank is called Long term funds.
Consider another example, If I have sufficient money for daily expenses for next three months, can I purchase a house from it? The answer is no as I do not have long term funds.
As is applicable to an individual same applies to a business as well.The business also needs short term funds and long term funds separately. Short term funds are required for day-to-day expenses for running the business. And long-term funds are required to buy the assets for the business which will be used for production in the long run.
So while assessing the health of a company we need to evaluate both its short term funds availability and long term funds availability. For evaluating long term funds availability we use Solvency ratios.
Example of a lemonade stand
Imagine that you are a company and you have a lemonade stand. You want to make more lemonade to sell, so you need to buy more lemons and sugar. You can either use your own money (like the money you saved up from your allowance or birthday gifts) or you can borrow money from someone else (like your parents or a bank).
The debt-to-equity ratio is a way to measure how much of your lemonade stand is financed by borrowing money versus how much is financed by using your own money. If you have a lot of debt (like if you borrowed a lot of money from your parents or a bank) and not much equity (like if you only have a little bit of your own money), it means that you're relying heavily on borrowing money to finance your lemonade stand because the borrowed money is to returned back someday. This could be a sign of financial risk. On the other hand, if you have a low debt-to-equity ratio, it means that you're not relying too much on borrowing money and are using more of your own money to finance your lemonade stand. This could be a sign of financial stability.
TYPES OF SOLVENCY RATIOS
There are four key types of solvency ratios :
- Debt Equity Ratio
- Total Assets to Debt Ratio
- Proprietary Ratio
- Interest Coverage Ratio
DEBT EQUITY RATIO
The debt-to-equity ratio is a financial ratio that measures the amount of a company's debt relative to its equity. It is calculated by dividing the company's total debt by its total equity. (for a more detailed discussion refer a separate article on Debt Equity Ratio)
The debt-to-equity ratio is used to evaluate a company's financial leverage, or the extent to which the company is using debt to finance its operations and growth. A high debt-to-equity ratio may indicate that a company has high levels of debt relative to its equity, which could be a sign of financial risk. On the other hand, a low debt-to-equity ratio may indicate that a company has low levels of debt relative to its equity, which could be a sign of financial stability.
Total Assets to Debt Ratio
The total assets to debt ratio is a financial measure that shows the proportion of a company's total assets that are financed through debt. It is calculated by dividing the company's total assets by its total debt.
This ratio is used to assess a company's financial leverage, or the extent to which it relies on borrowing to finance its operations and growth. A high total assets to debt ratio indicates that a company has a large amount of assets relative to its debt, which may be seen as a sign of financial stability. On the other hand, a low total assets to debt ratio may indicate that a company is more heavily reliant on borrowing, which can increase its financial risk. (for a more detailed discussion refer a separate article on total assets to debt Ratio)
Proprietary Ratio
Proprietary ratio, also known as the equity ratio, is a financial measure that shows the proportion of a company's total assets that are financed through equity, rather than debt. It is calculated by dividing the company's total equity by its total assets.
The proprietary ratio is used to assess a company's financial leverage, or the extent to which it relies on borrowing to finance its operations and growth. A high proprietary ratio indicates that a company has a large amount of equity relative to its assets, which may be seen as a sign of financial stability. On the other hand, a low proprietary ratio may indicate that a company is more heavily reliant on borrowing, which can increase its financial risk. (for a more detailed discussion refer a separate article on total assets to debt Ratio)
Interest Coverage Ratio
The interest coverage ratio is a financial measure that shows a company's ability to pay the interest on its outstanding long term debt. It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expenses on long term debt for a given period of time.
A high interest coverage ratio indicates that a company has a strong ability to pay the interest on its debt, while a low interest coverage ratio may indicate that the company is struggling to meet its interest payments. For example, a company with an interest coverage ratio of 2.0 or higher is generally considered to have a strong ability to pay its interest expenses, while a company with an interest coverage ratio below 1.0 may be seen as having a weaker ability to pay its debts.