Debt – equity ratio is one of the commonly used solvency ratios. This ratio indicates the extent to which company uses debt to fuel its growth. Too high debt- equity ratio indicates that the company is aggressive in feeding growth by using higher debt. This could mean a risky scenario for the investors. On the other hand, too low debt – equity ratio hints towards the inability on the part of the company to raise debt owing to thin operating margin.
Solvency Ratio Example
A comparative study was conducted between ABB and Rockwell using ratio analysis. This was undertaken in order to determine the financial performance of both the multinational electric companies.
As per the study, it was concluded that both ABB and Rockwell had an average debt – equity ratio of 0.65 between 2015 – 2016. This was way below 2:1, which is typically taken as the ideal DE ratio by investors. Although this may vary by industry. Such a low ratio indicated that both the companies were dependent more on equity than debt for their capital expenditure needs. They were not taking benefit of permanent stock investment for raising funds from outsiders. Thus, both ABB and Rockwell could have increased return on equity for their common stockholders. This could have been achieved by increasing the debt component of the capital structure.
So let’s understand what is the meaning of solvency ratios and why are they important. Then, we will dig deep into the type of solvency ratios and their interpretation.
What are Solvency Ratios?
The term solvency refers to the ability of the company to meet its long – term debt obligations. These long – term debt obligations include the company’s interest and principal payments on its loans. Now, one needs to undertake an exhaustive study of its capital structure components. This is done in order to determine the company’s ability to fulfill its long – term financial obligations.
So, this is where the solvency ratios come in useful for financial managers. Thus, solvency ratios help in determining the amount of debt used by the company as against the owner’s fund. Further, these help in ascertaining if the company’s earnings and cash flows are sufficient to meet interest expenses as they accrue in future.
Why Is It Important To Determine The Solvency of a Company?
Analyzing solvency ratios regularly can help a small business owner to be sure of the financial health of his business. Likewise, there are several reasons why business owners and financial managers seek to ascertain and analyse various solvency ratios. Some of them are as under:
- Through solvency ratios, business owners are able to study the debt component in the company’s capital structure. This further helps them in understanding the risk and return implications of debt for the company (specifically the operating and financial leverage). Here, Operating Leverage is the outcome of fixed costs used to conduct the business. And Financial Leverage is the result of fixed costs used for financing company via debt. Therefore, the operating ratio determines the extent to which company can increase its operating income by increasing sales. Whereas, the financial leverage is funding of assets via debt with an expectation that return from new assets would exceed the cost of borrowing.
- Analyzing solvency ratios help business owners in making decision with regards to taking additional debt. Too much of debt can make it difficult for the company to manage increased interest obligations.
These give confidence to the lenders and investors that the company would be able to meet its future financial obligations.
- Solvency ratio analysis helps the business owners to compare their solvency with the industry players. Thus, it gives a fair picture of its creditworthiness.
Types of Solvency Ratios
There are two types of Solvency Ratios that companies typically use to analyse their solvency position. These include Debt Solvency Ratios and Coverage Solvency Ratios. Debt ratios concentrate on the balance sheet and measure the amount of debt as against equity.
On the other hand, Coverage ratios concentrate on the income statement and measure the potentiality of the company to meet its debt payments. Here are the solvency ratios commonly used by the companies:
1. Debt Ratios
a. Debt to Equity Ratio
This solvency ratio measures the amount of debt taken by a business as against the equity. It helps in determining the financial leverage of the business i.e. the amount of debt taken by the company to finance its assets with an intent to increase shareholders value.
It is calculated by dividing company’s total liabilities by shareholders equity. This is one of the important ratios used by financial managers to understand the solvency of a company. Thus, the formula for Debt Equity Ratio is as follows:
Debt Equity Ratio = Long Term Debt/Shareholder’s Fund
Shareholder’s Funds (Equity) = Share Capital + Reserves and Surplus + Money received against share warrants
Share Capital = Equity share capital + Preference share capital
Shareholders’ Funds (Equity) = Non-current sssets + Working capital – Non-current liabilities
Working Capital = Current Assets – Current Liabilities
A high debt to equity ratio suggests higher debt and thereby risk on the part of the business entity to meet the debt obligation.
However, higher debt may also lead to higher returns for the owners. This is possible in cases where business entities are able to achieve ‘Trading on Equity’ – that is where rate of earnings on capital invested in the business is more than the rate of interest paid on debt to the outsiders.
Similarly, a low debt – equity ratio means more security on part of the business entity.
b. Debt to Total Assets Ratio
This is the ratio between debt and total assets of a business entity. The term ‘Debt’ means the total debt – that is it includes both the short term or current liabilities as well as long term liabilities of the business entity.
This ratio is an indicator of the financial leverage of a business entity i.e. the percentage of assets that have been financed with debt. In other words, the percentage of total assets that have been paid for by using debt. Thus, a higher debt to total assets means higher financial leverage and thus greater risk for the business entity.
c. Debt to Capital Employed Ratio
Debt to capital employed ratio is nothing but a ratio of long term debt to total capital of the firm i.e. debt plus equity. Thus, this ratio indicates debt as a percentage of the total capital of the business entity. It is calculated as follows:
Debt to Capital Employed Ratio = Long term debt/ Capital Employed
Where capital employed is nothing but long term debt plus shareholders fund.
Thus, Debt to capital employed ratio indicates the portion of long term debt in the capital employed in the business. A higher debt, although risky, helps the business owners in ensuring higher returns via trading on equity. On the other hand, a lower debt to capital employed ratio gives security to the lenders.
d. Proprietary Ratio
Where debt to total assets ratio ascertains the amount of assets financed with debt, Proprietary ratio determines the percentage of assets financed with equity.
In other words, Proprietary ratio indicates the contribution of shareholders to the total capital of the business entity. In order to determine Proprietary ratio, financial experts typically take total tangible assets in the denominator – that is they exclude goodwill and intangible assets like patents, trademarks etc.
This is done to get a true view of the entity’s financial position. It is calculated as follows:
Proprietary Ratio = Total Shareholder’s Equity/ Total Tangible Assets
A higher proprietary ratio indicates that a greater percentage of the entity’s assets have been financed with the owners funds. This is actually good for the business since it suggests a stable financial position of the business entity and gives higher security to the business lenders.
However, too high a Proprietary ratio suggests that the business entity has not taken the benefit of debt financing as it is using costly equity capital to finance its operations. Thus, a balance between debt and equity is what business entity must aim for.
2. Coverage Ratios
a. Interest Coverage Ratio
Interest coverage ratio determines the number of times a business entity’s Earnings Before Interest and Taxes (EBIT) can pay for its interest. In other words, this ratio determines the ease with which a business entity is able to pay for its interest on outstanding debt obligation. Therefore, it is also called ‘Times Interest Earned Ratio’. It is calculated as follows:
Interest Coverage Ratio = Earnings before Interest and Taxes/Interest Expense
A higher interest coverage ratio signifies good financial health of the business entity as it has more than sufficient earnings to pay for its interest obligations. Thus, this is a ratio typically used by lenders to ascertain the risk of lending to the business entity.
b. Fixed Charge Coverage Ratio
Fixed Charge Coverage Ratio shows the relationship between fixed charges or obligations of an entity to the cash flow generated by it. Thus, it estimates number of times the business entity’s earnings (that is Earnings before Interest, Taxes and Lease Payments) can cover the entity’s interest and lease payments.
The Formula for Fixed Charge Coverage Ratio is as follows:
Fixed Charge Coverage Ratio = (EBIT + Lease Payments)/(Interest Payments + Lease Payments)
Just like Interest Coverage Ratio, a high Fixed Charge Coverage Ratio indicates solvency of the company. Thus, it assures that the business entity has the capability to service its debt obligations from its earnings.
Furthermore, a high Fixed Charge Ratio also indicates stronger preferred dividend.