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.
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.
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.
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.