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Understanding Solvency Ratios

Solvency ratios measure a company's ability to pay off long-term debt and interest payments over the long run. They help business owners and creditors determine the company's chances of long-term survival by evaluating assets, debt, and equity levels. Specifically, solvency ratios assess how much debt is used to finance assets, what percentage of the company is owned by investors, and the company's ability to cover interest expenses with earnings. Monitoring solvency ratios can help identify financial trends that could potentially lead to bankruptcy if not addressed.

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Prerna Budhraja
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19 views2 pages

Understanding Solvency Ratios

Solvency ratios measure a company's ability to pay off long-term debt and interest payments over the long run. They help business owners and creditors determine the company's chances of long-term survival by evaluating assets, debt, and equity levels. Specifically, solvency ratios assess how much debt is used to finance assets, what percentage of the company is owned by investors, and the company's ability to cover interest expenses with earnings. Monitoring solvency ratios can help identify financial trends that could potentially lead to bankruptcy if not addressed.

Uploaded by

Prerna Budhraja
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Solvency ratios measure the ability of a company to pay its long­term debt and 

the interest on that debt. Solvency ratios, as a part of financial ratio analysis, help the 
business owner determine the chances of the firm's long­term survival. Solvency 
ratios are sometimes confused with liquidity ratios. Both assess a company's financial 
health.

But solvency ratios assess the company's long­term health evaluating long­term debt 
and the interest on that debt; liquidity ratios assess the company's short­term ability to 
meet current obligations and turn assets into cash quickly.

Solvency ratios are of interest to long­term creditors and shareholders. These groups 
are interested in the long­term health and survival of business firms. In other words, 
solvency ratios have to prove that business firms can service their debt or pay the 
interest on their debt as well as pay the principal when the debt matures.

Solvency ratios also help the business owner keep an eye downtrends that could 
eventuate in a possible bankruptcy. As the Debt/Asset ratio increases, the likelihood 
of bankruptcy also increases as the firm is financed more and more with debt as 
opposed to equity sources.

Solvency Ratios

There are several different solvency ratios, some of them technical and of use 
primarily to auditors or corporate analysts, others easily assessed and of interest to 
professional accountants, business owners and shareholders alike. A few of these 
basic solvency ratios are:

1. The Total Debt/Total Assets Ratio, measures how much of the firm's asset 
base is financed using debt. If a firm's debt ratio is .5, that means for every 
dollar of debt there are two asset dollars, or, putting it another way, that the 
firm's equity totals twice its debt.

2. The Equity Ratio explains how much of the company is owned by its 
investors. The Equity Ratio is calculated by dividing total equity by total 
assets. It answers a basic, but very important question: if the company goes out 
of business after it pays all liabilities how much will be left for its investors.

3. Interest Earned measures a company's ability meet its long­term debt 
obligations. It's calculated by dividing corporate income before interest and 
income taxes (commonly abbreviated EBIT) by interest expense related to 
long­term debt.

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