By: Shaun From: www.myaccountingcourse.com
Solvency ratios, also called leverage ratios, measure a company’s ability to sustain operations indefinitely by comparing debt levels with equity, assets, and earnings. In other words, solvency ratios identify going concern issues and a firm’s ability to pay its bills in the long term. Many people confuse solvency ratios with liquidity ratios. Although they both measure the ability of a company to pay off its obligations, solvency ratios focus more on the long-term sustainability of a company instead of the current liability payments.
Solvency ratios show a company’s ability to make payments and pay off its long-term obligations to creditors, bondholders, and banks. Better solvency ratios indicate a more creditworthy and financially sound company in the long-term.
The most common solvency ratios include:
Debt to Equity Ratio
The debt to equity ratio is a financial, liquidity ratio that compares a company’s total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders). Each industry has different debt to equity ratio benchmarks, as some industries tend to use more debt financing than others. A debt ratio of .5 means that there are half as many liabilities than there is equity. In other words, the assets of the company are funded 2-to-1 by investors to creditors. This means that investors own 66.6 cents of every dollar of company assets while creditors only own 33.3 cents on the dollar. A debt to equity ratio of 1 would means that investors and creditors have an equal stake in the business assets.
A lower debt to equity ratio usually implies a more financially stable business. Companies with a higher debt to equity ratio are considered more risky to creditors and investors than companies with a lower ratio. Unlike equity financing, debt must be repaid to the lender. Since debt financing also requires debt servicing or regular interest payments, debt can be a far more expensive form of financing than equity financing. Companies leveraging large amounts of debt might not be able to make the payments. Creditors view a higher debt to equity ratio as risky because it shows that the investors haven’t funded the operations as much as creditors have. In other words, investors don’t have as much skin in the game as the creditors do. This could mean that investors don’t want to fund the business operations because the company isn’t performing well. Lack of performance might also be the reason why the company is seeking out extra debt financing forming well. Lack of performance might also be the reason why the company is seeking out extra debt financing.
The equity ratio is an investment leverage or solvency ratio that measures the amount of assets that are financed by owners’ investments by comparing the total equity in the company to the total assets. The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets. The second component inversely shows how leveraged the company is with debt. The equity ratio measures how much of a firm’s assets were financed by investors. In other words, this is the investors’ stake in the company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that were financed by debt. Companies with higher equity ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.
In general, higher equity ratios are typically favorable for companies. This is usually the case for several reasons. Higher investment levels by shareholders shows potential shareholders that the company is worth investing in since so many investors are willing to finance the company. A higher ratio also shows potential creditors that the company is more sustainable and less risky to lend future loans. Equity financing in general is much cheaper than debt financing because of the interest expenses related to debt financing. Companies with higher equity ratios should have less financing and debt service costs than companies with lower ratios. As with all ratios, they are contingent on the industry. Exact ratio performance depends on industry standards and benchmarks.
Debt ratio is a solvency ratio that measures a firm’s total liabilities as a percentage of its total assets. In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets. In other words, this shows how many assets the company must sell in order to pay off all of its liabilities. This ratio measures the financial leverage of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders. This helps investors and creditors analysis the overall debt burden on the company as well as the firm’s ability to pay off the debt in future, uncertain economic times.
The debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets. As with many solvency ratios, a lower ratios is more favorable than a higher ratio. A lower debt ratio usually implies a more stable business with the potential of longevity because a company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but .5 is reasonable ratio. A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities. Or said a different way, this company’s liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company’s assets and the shareholders own the remainder of the assets. A ratio of 1 means that total liabilities equals total assets. In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm.
“Do you know your numbers? Knowing your numbers starts with knowing and understanding how the numbers are generated”.