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Solvency / Leverage ratios are a lot similar to liquidity ratios. As we learned earlier, liquidity ratios measure the company's ability to pay off short-term debts, whereas solvency ratios measure the ability to pay off long-term debt obligations of a company.
What are Solvency Ratios?
The term solvency implies the ability of the enterprise to meet future long-term obligations. Measures of long-term solvency attempt to examine a firm's capacity to meet interest and principal payments due in the forthcoming years. It provides information regarding the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses as they come due.
The different types of Solvency ratios are:
1. Debt-to-Equity Ratio:
This ratio measures the degree of indebtedness of a business enterprise.
Long-term debt along with interest-bearing short-term debt should be taken as the total debt and equity includes equity share capital, preference share capital, general reserves and surplus.
Higher the debt-to-equity ratio, higher the financial risk of leverage. However, this higher leverage also allows a successful company to increase the return to equity shareholders. It is because a company whose Return on Capital (ROC) is more than the cost of debt benefits equity holders by increasing debt in the capital structure.
The ratio is comparatively higher for the industries that require huge capital requirement like capital goods, infrastructure and real estate and is comparatively lower for the service sector industries like IT and FMCG
Safe debt level:
There is a notion of a safe debt level of a company. Although it is difficult to establish the 'safe debt level', it is determined with reference to the operating leverage of the company. Operating leverage measures the proportion of fixed costs in the operating costs structure.
A company with high variability in earnings or operating cash flow should have relatively low debt in its capital structure or else the company could go bankrupt.
A company which has a debt level lower than that of the safe level determined for the company is said to be underutilizing its debt capacity. Companies prefer to have debt lower than the safe level so that it does not face difficulties in obtaining additional debt financing when needed.
2. Debt-to-Asset Ratio:
This ratio measures the percentage of the total assets that is financed by the debt levels of the company rather than equity.
For example, a debt-to-asset ratio of 0.35 or 35% indicates that 35% of the company’s total assets are financed by debt.
Generally, higher debt to asset ratio signifies higher financial risk of the company and lower ratio indicates lower financial risk of the company.
3. Financial Leverage Ratio:
This ratio measures the amount of total assets that is supported by each one money unit of equity.
For example, a value of 3 for this ratio means that each ₹1 of equity supports ₹3 of total assets.
The higher the financial leverage ratio, the more leveraged the company is in the sense of using debt and other liabilities to finance assets and vice versa.
4. Interest Coverage Ratio:
This ratio shows whether or not a firm is in a position to meet its present obligations of long-term debt. It measures the number of times a company’s EBIT could cover its interest payments. The higher the ratio, the better off will be the firm's creditors.
Interest coverage ratio directly measures the ability of the company to meet its fixed commitment and continue its operations. A higher ratio indicates stronger solvency, offering greater assurance that the company can service its debt from operating earnings.
Analysts usually consider interest coverage ratio of 3 as adequate however, it varies from industry to industry.
5. Fixed Charge Coverage:
This ratio relates fixed charges, or obligations, to the cash flow generated by the company. It measures the number of times a company’s earnings (before interest, taxes, and lease payments) can cover the company’s interest and lease payments.
Here lease payments which a company has a commitment to make are added back to EBIT in the numerator and also to the denominator.
Significant lease obligations will reduce this ratio compared to the interest coverage ratio. A fixed charge coverage ratio is a more meaningful measure for companies that take on lease a large portion of their assets, such as some airlines or oil exploration companies that take on lease oil rigs for their exploration processes.
Fixed charge coverage ratio is a more comprehensive coverage ratio. A higher fixed charge coverage ratio implies stronger solvency, offering greater assurance that the company can service its debt (i.e., bank debt, bonds, notes, and leases) from normal earnings. The ratio is sometimes used as an indication of the quality of the preferred dividend with a higher ratio indicating a more secure preferred dividend. Usually, a fixed charge coverage ratio of less than 1 is considered to be inadequate. Analysts consider that earnings of a company with a fixed charge coverage ratio of less than one are insufficient to cover fixed charges.
Let’s calculate solvency ratio with the given information:
- Debt= ₹10,65,000
- Shareholder's equity= ₹10,31,300
- Total Assets= ₹2,412,200
- EBIT (Earnings Before Interest and Taxes)= ₹4,24,900
- Interest Payments= ₹46,900
1) Debt-to-Equity ratio =Total Debt/Total Shareholders’ Equity
= 10,65,000/10,31,300 = 1.03
2) Debt-to-Asset ratio = Total Debt/Total Assets
= 10,65,000/24,12,200 = 0.44
3) Financial Leverage = Average Total Assets/Average Total Equity
= 24,12,200/10,31,300 = 2.34
4) Interest Coverage ratio = EBIT/Interest Payments
= 4,24,900/46,900 = 9.06
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