What Are Solvency Ratio and What Do They Measure ?

Posted by ashagawade6 on July 27th, 2017

Solvency ratios measure the ability of a company to pay its long-term debt and the interest on that debt. Solvency ratio, as a part of financial ratio analysis, help the business owner determine the chances of the firm's long-term survival. Solvency ratio  are sometimes confused with liquidity ratios. Both assess a company's financial health.

What Are Solvency Ratios Good for?

Solvency ratio  are of interest to long-term creditors and shareholders. These groups are interested in the long-term health and survival of business firms. In other words, solvency ratio 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

There are several different solvency ratio, 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.

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

What Is a Good Solvency Ratio?

Relatively minor deviations from the ratios of the dominant players (which will also differ from one to another) are likely not meaningful. If one of the ratios shows limited solvency, that's a problem. If several of these ratios all point to low solvency, that's a determining issue.

Source: thebalance /what-are-solvency-ratios-and-what-do-they-measure-393211