Solvency Ratio — Microsoft Excel
In this article, we will delve into the intricacies of solvency ratios and along with that we also cover it’s important concepts that is frequently used in accounting and finance with different approaches.
Let’s Dive In
Solvency Ratio
They are calculated to understand companies’ capability to repay long term debts and obligations. These ratios are commonly used for lenders and banks. If these
ratios are not in ideal positions, it indicates that the company is in trouble and will default on its obligations. These ratios indicate whether a company stays solvent in the long term. We can measure a company’s cash flow capacity with these ratios. Solvency ratios are also known as leverage ratios.
They cannot be compared across industries, for example, a coal manufacturing company cannot be compared with a coal trading company.
Types of solvency ratio are listed below:
- Debt Equity Ratio
- Debt to Assets Ratio
- Debt to Capital Ratio
- Interest Coverage Ratio
- Debt Service Coverage Ratio
- Capital Gearing Ratio
Debt Equity Ratio
It calculates the weight of the total debts and obligations against total shareholders’ equity. A higher debt equity ratio indicates a higher risk of solvency.
Formula:
Where total liabilities include all short term and long term debts, and total shareholder’s equity includes all types of equity. Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, Situation B is better than A because we have enough
equity to meet our long term liabilities and obligations. Situation A has a higher
risk of solvency.
Ideally, D/E < 1
Companies with low D/E ratios survive better. Manufacturing companies, banks and power companies have higher D/E ratios and retail and software companies have lower D/E ratios because they don’t usually need debt.
Debt to Assets Ratio
It calculates the weight of the total debts and obligations against total assets. A higher debt to assets ratio indicates a higher risk of solvency.
Where total liabilities include all short term and long term debts, and total assets include all types of assets. Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, Situation B is better than A because we have enough
assets to meet our long term liabilities and obligations. Situation A has more risk of
solvency.
Ideally, D/A < 0.5
Companies with low D/A ratios survive better. Manufacturing companies, banks and power companies have higher D/A ratios and retail and software companies have lower D/A ratios because they don’t usually need debt.
Debt to Capital Ratio
It calculates the weight of the total debts and obligations against the total liabilities.
A higher debt to capital ratio indicates a higher risk of solvency.
Formula:
Where total liabilities include all short term and long term debt, and total capital includes all short term and long term debt and shareholders equity. Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, Situation B is better than A because we have enough cash
flow to meet our long-term liabilities and obligations. Situation A has a higher risk
of solvency.
Ideally, D/C < 0.5
Companies with low D/C ratios survive better. Manufacturing companies, banks and power companies have higher D/A ratios and retail and software companies have lower D/A ratios because they don’t usually need debt.
Interest Coverage Ratio (ICR)
It calculates how many times a company’s operating profit covers its interest payments. It measures how a company can pay the interest due on outstanding
debt. Some companies use EBIT, some use EBITDA and some use EBIAT. We will consider this only with EBIT to avoid confusion, as EBIT is in practice mostly. The
lower the ratio, the higher the chance of default.
Formula:
Where EBIT is Earning Before Interest and Taxes, a component of the income statement and interest payment includes interest paid as per the income statement.
Let’s take an example to understand this better by focusing on the figure below.
As we can see in the above figure, Situation A is better than B because we have higher ICR
meet our debt interest payment, whereas ICR in Situation B is 1.43. Situation B has a higher risk of solvency.
Ideally, ICR > 3.
A higher ICR means that the company generates more earnings relative to its interest expense, which gives it a greater cushion to absorb any adverse financial
events or economic downturns. As such, investors and analysts often view a high ICR as a positive sign of a company’s financial health and stability. Manufacturing
companies, banks and power companies have lower ICR and retail and software companies have lower ICR or might not be required to calculate ICR because they don’t usually need debt.
Debt Service Coverage Ratio (DSCR)
It calculates how many times a company’s operating profit cover its debts service, Principal Amount + Interest Amount or we can say 12 EMIs, payments. It measures
how a company can repay its debt and interest on outstanding debt. Some companies use EBIT, some use EBITDA and some use EBIAT. We will consider this only with
EBIT to avoid confusion, as EBIT is in practice mostly. The lower the ratio, the higher the chance of default.
Formula:
Where EBIT is Earning Before Interest and Taxes, a component of the income statement and debt service includes principal paid and interest paid as per the income statement. Let’s take an example to understand this better by looking the figure below.
As we can see in the above figure, Situation A is better than B because we have a higher
DSCR to meet our debts service, while the DSCR in Situation B is 0.19. Situation B has a higher risk of solvency.
Ideally, DSCR > 1.
A higher Debt Service Coverage Ratio (DSCR) generally indicates a stronger solvency position for a company and an ability to make debt interest payments more easily. In other words, the higher the DSCR, the more capable a company is of meeting its
debt obligations, which in turn can increase its chances of survival and financial success.
Manufacturing companies, banks and power companies have lower DSCR and retail and software companies have lower DSCR or might not even be required
to calculate it because they don’t usually need debt.
Capital Gearing Ratio (CGR)
It calculates how capital is geared equity to total debt ratio. The higher geared the ratio, the higher the chance of default.
Formula:
Where common stockholder’s equity is total shareholder’s fund and deduct preferred stock, Share Capital + Reserve and Surplus and fixed interest bearing funds include total debt and preference shares.
Let’s take an example to understand this better by looking at the figure below.
As we can see in the above figure, Situation A is better than B because we have a lower CGR
in Situation A, the CGR in Situation B is 1.36, so it has a higher risk of solvency.
Ideally, CGR <0.25.
A lower Capital Gearing Ratio means that the company has a lower level of debt relative to its equity, which gives it greater financial flexibility and reduces its risk of default.
- CGR>1 Very high geared, risk of solvency is very high.
- CGR<0.5 - 1 – Higher geared, risk of solvency is high.
- CGR<0.25 - 0.5 – Optimal geared, risk is optimal for these companies
. - CGR<0.25 – Low geared, low risk.
Conclusion
As we look any finance professional in the company and sometimes we think it’s quit simple, but the reality is, it deals with heavy financial statements, billing preparation and complex auditing. In today’s guide we will learning the fundamentals of solvency ratios and it’s different types that matters for company up/down financial trends and whenever we see as the market perspective it will also help us there as well and throughout our business operations and also other financial projections. It will display overall conditions of our business financially.
