Hi, welcome to the third installment of the Financial Analysis Techniques series. In the first post of this series we covered activity ratios – which are ratios that indicate operational efficiency of the firm or how well the assets are used. In the last post we covered Liquidity ratios that assess the liquidity position of a firm. In the next two posts we will cover profitability ratios and then look more closely at the most important profitability ratio- the ROE when we cover DuPont analysis of the ROE. For now though we will look into the various types of Solvency ratios and their use in financial analysis. So read on to find out what is a solvency ratio and the various solvency ratio formula.
Solvency ratio: Introduction
Solvency is a firm’s ability to meet its expenses in the long run. So what are solvency ratios? Solvency ratios are measures of solvency that measure the adequacy of a firm’s earnings and cash flows to cover long term obligations i.e. they measure long term solvency position of a firm. Solvency ratios also measure the efficient use of debt (leverage) in the capital structure of the firm.
A solvency ratio formula is made up of balance sheet and income statement items. The ‘debt’ solvency ratios are based on balance sheet items and the ‘coverage’ solvency ratios on income statement elements. So let us see below what are the different measures of solvency commonly used to analyze a firm’s solvency.
Different types of Solvency ratios: Debt Solvency ratios
Following is the ‘debt’ solvency ratios list;
‘Debt to equity’ solvency ratio formula
‘Debt to equity’ is one of the debt solvency ratios. It measures the proportion of debt in the capital structure relative to equity. The ‘Debt to equity’ solvency ratio formula is given as;
Debt to equity ratio = total debt / total shareholder’s equity
A higher ratio indicates higher reliance on debt and therefore lower solvency. Hence a lower ratio is preferred. However this is subjective as too low a ratio will indicate inadequate use of leverage.
‘Debt to capital’ solvency ratio formula
Debt to capital solvency ratio is another of the debt solvency ratios. The ‘debt to capital’ solvency ratio formula is given as;
Debt to capital = total debt / total shareholder’s capital
This ratio measures the proportion of debt in the capital structure. Again a higher or lower ratio will indicate the dependency on debt and the level of solvency.
‘Debt to assets’ solvency ratios
Debt to assets solvency ratio is yet another type of the debt solvency ratios. This solvency ratio formula is given as;
Debt to assets ratio = total debt / total assets
This ratio measures what proportion of the assets is financed by debt. A higher or indicates a higher level of leverage.
Financial leverage ratio or Leverage ratio
Financial leverage ratio is given as;
Financial leverage ratio = average total assets / average total equity
This is another way of measuring the proportion of assets financed by debt. A higher ratio indicates higher use of leverage financing to finance the assets. A lower ratio on the other hand indicates more assets have been financed with owned capital.
Coverage solvency ratios
Coverage solvency ratios as already stated before measure the adequacy of the firm’s earnings and cash flows to cover its long term obligations. Coverage ratios are made up of income statement elements. Following is the coverage solvency ratios list;
Interest coverage ratio
The interest coverage ratio measures if the earnings are sufficient to cover the interest payments to be made. A higher ratio indicates better coverage.
The interest coverage ratio formula is given as;
Interest coverage ratio = EBIT / interest payments
EBIT is short for ‘earnings before interest and taxes’. It is an item on the income statement. EBIT is the gross earnings of the firm after depreciation/amortization & operating expenses and before interest & taxes are deducted from it.
Fixed charge coverage ratio
Fixed charge coverage ratio measures the adequacy of earnings to cover all the fixed payments to be made by the firm, i.e. interest and lease payments. The fixed charge coverage ratio formula is given as;
Fixed charge coverage ratio = EBIT + lease payments/interest + lease payments
Here we add back the lease payments to EBIT in the numerator as we need to calculate the earnings available for making interest and lease payments. Needless to say again, higher the ratio the better the coverage.
That’s all in this post…hope you found it informative….in the next post we move on to the third installment of Financial Analysis Techniques – Profitability ratios….see u again soon…
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