Using Solvency Ratios to Better Understand Your Business

By Craig Anthony

2 min read

Solvency ratios is a group of accounting ratios that can help any small business owner better understand important aspects of his or her business. Here are examples of four different solvency ratios that any small business can use.

What Is a Solvency Ratio?

Solvency ratios, also called leverage ratios, measure a business’ ability to sustain operations. They do so by comparing debt, asset, equity, and earnings levels. These ratios help determine a business’ ability to pay its obligations in the long term. Stronger solvency ratios indicate a more creditworthy and financially healthy company.

Debt-to-Equity Ratio

The debt-to-equity ratio shows the percentage of financing that comes from creditors and investors. A higher D/E ratio indicates that more financing comes from lenders, such as bank loans, instead of investor financing. The formula is:

D/E = total liabilities / total equity

For example, assume a company has $400,000 in total liabilities and $200,000 in equity. The D/E ratio is:

$400,000 / $200,000 = 2

This means there is $2 of debt financing for every $1 in equity financing, which is a rather dangerous position. Generally, the lower this ratio, the better.

Equity Ratio

The equity ratio shows how much of the business’ assets are financed by shareholders instead of debt. In other words, this ratio reveals the percentage of the company owned by investors. It is calculated as:

Equity ratio = total equity / total assets

For instance, assume a company has $500,000 in total equity and $600,000 in total assets. The equity ratio is:

$500,000 / $600,000 = 83.3%

This means only approximately 17% of the company is funded through debt, which is a strong sign.

Debt Ratio

The debt ratio measure how much of the company’s assets are funded by debt. This ratio shows the financial leverage of the company. As such, it is generally much better to have a lower debt ratio. The ratio is calculated as:

Debt ratio = total liabilities / total assets

For example, if the company has $800,000 in assets and $400,000 in total liabilities, the debt ratio is:

$400,000 / $800,000 = 50%

Depending on the industry, this may be considered rather high.

Times Interest Earned Ratio

This ratio is also called the interest coverage ratio. It measures the proportionate amount of income that can be used to cover interest expense on the company’s liabilities. It indicates the business’ ability to service its debt. Higher is always better, and anything less than 1 means the company can’t pay its bills.

It is calculated as:

Times interest earned = (income before interest and taxes , or EBIT) / interest expense

For example, if a business has an EBIT of $100,000 and an interest expense of $25,000, the ratio is calculated as:

$100,000 / $25,000 = 4

The business earns four times its debt service, meaning it is in a strong position.

References & Resources

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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