Solvency Ratio

The solvency ratio represents the company’s ability to meet its long-term obligations. Long-term obligations include interest payments and amortization of outstanding loans. 

Why is the solvency ratio important?

It is important because it highlights potential Cash flow issues for the future. Capital structure analysis uses the Solvency Ratio to highlight, where the company’s arrangement of Capital(“Equity & Debt”) to run the business.  Hence poor solvency ratio meant mismanagement or unsustainable usage of firm capital resources.

What is the Formula for Solvency Ratio?

As we previously mention, the solvency ratio is used for capital structure analysis(Equity & debt); There are 3 formulas used to determine the firm’s management of Debt and Equity.

Debt to Equity 

D/E= TOTAL Debt/ TOTAL Equity

The debt to Equity Ratio is commonly used to evaluate “How financially leverage a firm is.”  I will provide you with an example to best explain this concept. For example, If ABC company has a,

    1. D/E ratio of 1500/1500 =1
      We can say that for every dollar raised through shareholder’s Equity, there is a dollar financed from debt.
    2. D/E ratio of 2000/1000=2
      Likewise for a D/E of 2, for every dollar raised through shareholder’s Equity, there is Two dollars financed from debt.

Scenario two indicates that the firm is relying on debt to run the company. With a High D/E ratio, investors are concerned about the company’s cash flow ability to cover the cost of debt and a well-staggered debt expiry profile.

With a low D/E ratio, investors will be concerned about

    1. Dilution of their Equity stake *IF there is a year-over-year increase in Equity
    2. Slowing growth

Keep in mind that investors can’t reach any comprehensive conclusion with just a D/E ratio alone. More financial metrics and other qualitative data need to be accessed to reach any verdict.

Debt to Assets Ratio

D/A= TOTAL Debt/ TOTAL Assets

The Debt-Asset Ratio is also the financial leverage ratio. It tells us how much debt is relative to the company’s assets. The higher the D/A, the more leverage and financially inflexible the company is. The Lower the D/A ratio the better it is. Usually, a company that has a healthy cash flow, Low D/A ratio is called matured cash cows companies these companies are highly sorted after by value investors.

Interest coverage ratio

Coverage Ratio = EBIT/Interest Expense

The interest Coverage Ratio indicates the company’s ability to meet its debt expense. A high-interest coverage ratio means low chances of a firm defaulting on its debt. A high-interest coverage ratio also indicates a good profit margin. As a rule, Investors should avoid companies that have an interest coverage ratio of less than 2.5.

What is the difference between the Solvency Ratio and liquidity ratio?

The solvency Ratio represents the company’s ability to meet its long-term obligations, Liquidity ratio represents the company’s ability to meet its short-term debt obligations. Most investors use the Quick ratio(Acid test) to measure Liquidity Ratio.