Basic Business Calculations – Solvency Ratios
Business Calculations Part 2

Solvency ratios are used to assess a company’s ability to fulfil long-term debt obligations, regardless of cash flow. Essentially these ratios look at “financial risk” and the level of debt a company has and whether that level is acceptable or not.

Although there are several solvency ratios that one can use, these are two of the most commonly used ones:

Debt to Equity Ratio:

The debt-to-equity ratio is calculated by dividing Total Liabilities by Owner’s Equity (Total Assets – Liabilities) and measures the degree of financial leverage a company uses to enhance its return. Or in other words, it shows what proportion of equity and debt the company is using to finance its assets.

It must be mentioned that sometimes, when using this calculation, only interest-generating, long-term debt is used.

  • Total Liabilities/ Owner’s Equity (A-L)

So what do the results mean:

A high or rising debt-to-equity ratio would mean that a company has been financing its growth with debt ie. By purchasing fixed assets or inventory with loans. Paying off debt would help to improve the ratio.

The debt/equity ratio depends on the industry in which the company operates. Capital intensive businesses, such as the automotive industry, will tend to have higher debt to equity ratios than companies which are not capital intensive.

Debt to Assets Ratio:

This ratio measures the proportion of a business’s assets that are financed by creditors (loans) versus the proportion financed by business owners. It can be calculated using the following formula:

  • Total Liabilities/ Total Assets

So what do the results mean:

A debt-to-asset ratio of no more than 0.5:1 has been considered prudent. A higher ratio may indicate too much financial leverage and potential problems in meeting debt payments.

Increasing the value of assets or paying off debt will help to improve this ratio.

References:

https://www.toolkit.com
http://www.investopedia.com