Solvency Ratio: Types and Formula

What is Solvency Ratios?

Let’s start with the third classification of ratios, i.e., solvency ratios. In the previous chapter, we studied liquidity ratios that measure the ability of the firm to meet its short-term obligations. In contrast to liquidity ratios, solvency ratios measure a firm’s financial leverage and ability to meet long-term obligations. As business is assumed to be a going concern entity, evaluating its long-term paying capacity equally becomes important as certain liabilities may last for years. An investor should determine whether the company has sufficient resources to support these liabilities. 

Why are liabilities important to settle? This is so because liabilities are fixed charges for the company that it has to pay irrespective of the profit earned or losses incurred in the particular period, or scaling up or down its operations. There have been many instances in Indian stock market history where the company's failure to settle its long-term liabilities led to the filing of bankruptcy. 

With that in mind, let’s start with the first solvency ratio. Do note that most of the ratios ahead that we will study, will try to measure the company's long-term debt as a proportion of some other line item of financial statements like equity, capital, assets, etc. but in a nutshell, every ratio is more or less trying to capture debt as a proportion of something, and lower value of the ratio presents lower usage of debt by the company. 

1. Debt-to-equity ratio 

The debt-to-equity ratio measures the firm’s use of fixed-cost financing sources. It measures debt as a proportion of shareholder’s capital. 

Formula of debt to equity ratio:

Debt-to-equity ratio = Total debt / total shareholder’s equity 

Interpretation of the debt to equity ratio: 

Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing, respectively.

Please note that different investors and analysts and financial information providers usually calculate total debt differently. Here, we have defined it as long-term debt plus interest-bearing short-term debt.

Although it's the industry norm that the ideal value for this ratio should be 2, however, there is no such rule. Like any other ratio, it's advisable to compare the firm’s ratio with industry peers and then arrive at a conclusion. 

2. Debt-to-capital ratio 

Another way of looking at debt usage is the debt-to-capital ratio. It measures debt as a proportion of total capital. 

Formula of debt to capital ratio:

Debt-to-capital ratio = Total debt / Total debt + Total shareholder’s equity 

Here capital equals all short-term and long-term debt plus preferred stock and equity. Thus, the denominator is much broader in comparison to equity components. 

Interpretation of the debt to capital ratio: 

Just like the previous ratio, Increases and decreases in this ratio also suggest a greater or lesser reliance on debt as a source of financing.

3. Debt to Assets ratio

A slightly different way of analysing debt utilisation is the debt-to-assets ratio. This time rather than measuring debt as a proportion of capital, it is measured as a proportion of total assets. Some investors also interpret this ratio as the proportion of debt-fed assets. 

Formula of debt to assets ratio:
Debt-to-assets ratio = Total debt / total assets 

Interpretation of the debt to assets ratio: 

Increases and decreases in this ratio suggest a greater or lesser reliance on debt as a source of financing.

4. Financial leverage ratio 

Another measure to indicate a company’s use of debt financing is the financial leverage ratio (or simply leverage ratio). This ratio is also referred to as equity multiplier. This ratio provides insight into using debt to fund a company's assets. 

Formula of financial leverage ratio:
Leverage ratio = Average total assets / Average total equity 

Please note that the average here means the average of the values at the period's beginning and end. 

Interpretation of the financial leverage ratio: 

Greater use of debt financing increases financial leverage and, typically, risk to equity holders and bondholders alike.

In the chapter ahead, we will also study that the financial leverage ratio is a very important determinant in calculating returns on equity under Du Pont's analysis. 

5. Interest Coverage Ratio 

This ratio calculates the number of times of operating profit available to meet the company's interest payments. In other words, this ratio measures the ability of the firm to meet its interest obligations. 

Formula of interest coverage ratio:
Interest Coverage Ratio = Earnings before interest & taxes/interest payments 

Now you might wonder why EBIT is used instead of net profit. This is so because as we studied in the profit and loss chapter, EBIT is a better measure of operating profitability and is thus comparable between firms as it is not impacted by non-operating items like interest payments and taxes. 

Interpretation of the interest coverage ratio: 

• The higher value of this ratio is preferred as it gives the company enough cushion to meet its interest obligations. 
• The lower this ratio, the more likely the firm will have difficulty meeting its debt payments. This is so because as mentioned earlier, interest obligations are fixed charges that must be paid irrespective of profitability. 

Numerical example with solution

In the above section of this chapter, we discussed various solvency ratios. Applying and analysing the ratios on a company's actual financial statements is equally important. For this chapter, and going further we will be calculating and analysing the financial statements of XYZ Ltd. The financial statements of XYZ Ltd were discussed in detail in the financial statement chapters. The steps you need to follow to understand this section are simple:

Step 1 - Snapshots of the actual financial statements are provided below. These statements consist of the crucial financial statements of XYZ Ltd - Statement of profit and loss, balance sheet and cash flow statement. 

Step 2 - A table named ‘Data Extract’ is provided below the snapshot for easy understanding. This table will include all the important line items and related numerical data from the financial statements of XYZ Ltd., needed to calculate a particular category of the ratio, like in this chapter - solvency ratios. Please note all the amounts are in ₹ crores.

Step 3 - The solutions table is provided below the data extract table. This table includes the value of all the ratios taught in a particular chapter. However, you are expected to calculate the ratio value by yourself and then match your answers with the solution table to understand the concept better.

Step 4 - The analysis and interpretation section is provided towards the end. This includes the analysis of XYZ Ltd based on ratios calculated. 

Let’s start with the exercise:

Financial statements of XYZ Ltd 

Data extract:

Extract of data needed for solvency ratios
	[Amount in ₹ crores. ]	[Amount in ₹ crores. ]
Particulars	March 2023	March 2022
Total debt (both long term & short term)	998	867
Total shareholder's equity	9,441	8,421
Total capital	10,439	9,288
Total assets	13,654	12,284
Average total assets	12,969
Average total equity	8,931
Profit before tax	2,218	2,268
Finance cost (Interest payment)	78	39
EBIT	2,296	2,307

Solution:

Value of solvency ratios:
Debt to equity ratio	0.105
Debt to capital ratio	0.095
Debt to assets ratio	0.076
Financial leverage ratio	1.452
Interest coverage ratio	29.43

Analysis and interpretation 

• From the above solutions table, you can see that the solvency position of XYZ Ltd. seems to be very strong. 
• Interest-bearing debt as a proportion of equity, total capital, and total assets is very low. This means there are enough resources available at XYZ Ltd.'s disposal to meet its long-term borrowing commitments. 
• Even the interest coverage ratio is very high, which means sufficient profit is available to support the company's interest payments. 
• From another perspective, low solvency ratios also signal that XYZ Ltd. has sufficient borrowing capacity and thus can borrow long-term funds to fund its growth plans and expansion objectives. The company's creditors will be comfortable lending further to the company due to its strong solvency position. Of course, this should not be looked upon in isolation. Comparison with its historical value of ratios and peer comparison is equally important to conclude the findings. 

Where Can I Check Fundamental Ratios on Angel One?

In order to check valuation ratios on Angel One, simply:
1. Click on the stock from the search bar or from the Watchlist.
2. Click on ‘Overview’ and thereafter, click on ‘Stock Details’.
3. Scroll down and you will find fundamental ratios.

Summary of Solvency Ratios

Here we need to make a general note on why solvency ratios are important. Higher usage of debt can be beneficial to some extent as it is considered a cheap source of financing without diluting ownership interest for existing shareholders. However continuous reliance on debt can lead to a vicious circle of borrowing where new debt is taken to pay off existing debt. As the condition deteriorates, even the interest rate charged on new debt increases, leading to further increases in fixed-interest payments. This vicious circle ultimately leads to a debt trap and can result in the erosion of shareholder value over time. 

This was all about solvency ratios. In the next chapter, we will explore the fourth classification of financial ratios i.e. profitability ratios.