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EduPristine>Blog>Ratio Analysis – Solvency Ratios

Ratio Analysis – Solvency Ratios

August 21, 2014

solvency ratios

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In our earlier posts we have discussed Profitability Ratios and Liquidity Ratios. The capacity of

the business to meet its short-term and long term obligations can be generalized into the term

“Solvency”. Creditors, bank loans and bills payable etc come under the inclusion of Short Term

obligations. Long-term obligations broadly encompass – debenture, long-term loans and long-term

creditors etc. Solvency Ratios are an indication of the financial soundness of a business to continue

the operations of its business smoothly, without any impediments and meet its all obligations.

Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the

concern have already been explained. Now under this part of the chapter only the long-term

solvency ratios are dealt with. Some of the important ratios which are given below in order to

determine the solvency of the concerned:

  • Debt – Equity Ratio

  • Proprietary Ratio

  • Capital Gearing Ratio

  • Debt Service Ratio or Interest Coverage Ratio

1. Debt – Equity Ratio

This ratio is designed to ascertain the firm’s obligations to creditors in relation to funds invested by

the owners. It is an indication of all external liabilities to owner’s recorded claims.

Debt – Equity Ratio = Total Long Term Debts / Shareholders Fund

2. Proprietary Ratio

Proprietary Ratio is also termed as Capital Ratio or Net Worth to Total Asset Ratio. It serves as one

of the variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth. The relationship

between shareholders’ fund and total assets is formed by this ratio.

Proprietary Ratio = Shareholders Fund/ Total Assets

3. Capital Gearing Ratio

This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term

capital gearing refers to describe the relationship between fixed interest and/or fixed dividend

bearing securities and the equity shareholders’ fund.

Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds

4. Debt Service Ratio or Interest Coverage Ratio

Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed Charges Cover Ratio. This ratio

denotes the equation between the amount of net profit before deduction of interest and tax and

the fixed interest charges. It is used as a yardstick for the lenders to gain an insight that the business

concern will be able to pay its interest periodically.

Debt Service Ratio or Interest Coverage Ratio = Net profit before Interest & Taxes / Fixed Interest Charges

5. OVER ALL PROFITABILITY RATIOS

The overall profitability of a firm on the extent of operating efficiency it enjoys. This ratio establishes

the relationship between profitability on sales and the profitability on investment turnover.

Overall Profitability Ratio = Net Profit / Total Assets

The lower a company’s solvency ratio, the greater the probability that it will default on its debt

obligations.

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