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Solvency ratios measure a company’s ability to pay off its long-term obligations such as bank loans, bonds payable, etc. Better solvency ratios indicate a more creditworthy and financially sound company in the long-term. Shareholder’s Funds (Owner’s Equity) portion out of the total liabilities determines the Solvency of a company.

Types of Solvency Ratios

Conmanly used Solvency Ratios are

  1. Debt to Equity
  2. Debt to Assets
  3. Times Interest Earned
  4. Debt to Capital

Debt to Equity

It is defined as the ratio of company’s total liabilities divided by it’s total assets. Higher ratio implies more obligations both short and long term a company has.

Debt to Equity = Total Liabilities / Shareholders Equity

Both total liabilities and shareholders equity figures can be obtained from balance sheet. Other variation of above formula uses only the interest bearing long-term liabilities in the numerator.

Debt to Assets

It measures debt of a company as a percentage of its total assets. It is defined as the ratio of total debt of a company divided by its total assets.

Debt to Assets = Total Debt / Total Assets

Total debt equals long-term debt and short-term debt. It is equivalent to total liabilities minus non-debt liabilities such as accounts payable, salaries payable, etc. Total assets include both current assets and non-current assets.

Times Interest Earned

It measures if a company has earned enough profits to make its interest payments. It is defined as the EBIT (Earnings before Interest and Tax) divided interest expense.

Times Interest Earned = Earnings before Interest and Tax / Interest Expense

A higher times interest earned ratio indicates that the company’s interest expense is low relative to its EBIT which indicates better long-term financial strength, and vice versa.

Debt to Capital

It measures how much of the capital employed is debt. It is defined as ratio of interest-bearing debt to the sum of interest-bearing debt and shareholders equity.

Debt to Capital = Interest bearing Debt / (Interest bearing Debt + Shareholders Equity)

Interest bearing debt includes bonds payable, bank loans, notes payable, etc. Non-interest bearing debt includes trade payable, accrued expenses, etc.

Reference

Solvency ratio