Solvency refers to a company's ability to fulfil its long-term debt obligations. Assessment of a company’s ability to pay its long term obligations (interest and principal payments) generally includes an in-depth analysis of the components of its financial structure. Solvency ratios provide information regarding the relative amount of debt in the company ’ s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges as they come due.
Solvency ratios are primarily of two types. Debt ratios, the first type, focus on the balance sheet and measure the amount of debt capital relative to equity capital. Coverage ratios, the second type, focus on the income statement and measure the ability of a company to cover its debt payments. All of these ratios are useful in assessing a company’s solvency and, therefore, in evaluating the quality of a company’s debt obligations. The following chart describes commonly used solvency ratios.
Solvency Ratios Numerator Denominator
Debt-to-assets ratio Total debt Total assets
Debt-to-capital ratio Total debt Total debt + Total shareholders’ equity
Debt-to-equity ratio Total debt Total shareholders’ equity
Financial leverage ratio Average total assets Average total equity
Interest coverage EBIT Interest payments
- Debt - to - assets ratio: This ratio measures the percentage of total assets financed with debt. For example, a debt - to - assets ratio of 0.40 or 40 percent indicates that 40 percent of the company’s assets are financed with debt. Generally, higher debt means higher financial risk and thus weak solvency.
- Debt - to - capital ratio: The debt - to - capital ratio measures the percentage of a company’s capital (debt plus equity) represented by debt. As with the previous ratio, a higher ratio generally means higher financial risk and thus indicates weaker solvency.
- Debt - to - equity ratio: The debt - to - equity ratio measures the amount of debt capital relative to equity capital. Interpretation is similar to the preceding two ratios (i.e., a higher ratio indicates weaker solvency). A ratio of 1.0 would indicate equal amounts of debt and equity, which is equivalent to a debt - to - capital ratio of 50 percent.
- Financial leverage ratio: This ratio measures the amount of total assets supported for each one money unit of equity. For example, a value of 5 for this ratio means that each $. 1 of equity supports $. 5 of total assets. The higher the financial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to finance assets. This ratio is often defined in terms of average total assets and average total equity.
- Interest coverage: Another measure of financial leverage is the extent to which interest is covered by earnings. Banks prefer to lend to firms whose earnings are far in excess of interest payments. Therefore, analysts often calculate the ratio of earnings before interest and taxes (EBIT) to interest payments. A higher interest coverage ratio indicates stronger solvency, offering greater assurance that the company can service its debt from operating earnings.
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