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Solvency Ratios

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What is Solvency Ratio?

Solvency ratio is one of the various accounting ratios that is seized in order to determine the capability of the organization to overcome the long term debts. The solvency ratio specifies the size of the company after the taxes and other obligations have been deducted from the actual income or the profit, and find out the net income of the company.

Solvency ratios are also known as the leverage ratios. These ratios help in analyzing the ability of the unit to work on the debts of the company. The main object of the calculation of the solvency ratios is to find out if the company is able to meet the long term arrears. The solvency ratios are very important for the investors as they are able to know about if the investments made by the stakeholders are safe and secure to continue dealing with the company.

The basic and the main difference between the liquidity and the solvency ratios is that the liquidity ratios compare the current assets and current liabilities, whereas the solvency ratios take care of the long term debts.

Types of Solvency Ratios

1. Debt to equity ratio

The debt to equity ratio is used to measure the relationship between the debt that is for a longer period of time of the organization to the total equity of the firm. Because, both the figures are obtained from the balance sheet, therefore, it is also known as the balance sheet ratio.

Formula:

Debt to equity ratio= long term debts/ shareholders’ funds

Long term debt= debentures + long term loans

Shareholders’ funds= equity share capital+ preference share capital + reserves- fictitious assets

1. Debt ratio

The debt ratio is used to measure the long term debts of the organization by comparing it with the total capital employed. If not the capital employed, the figure of the net assets can be used. So, the debt ratio will determine the liabilities (long- term) of the organization as a percent of its long term possessions.

Formula:

Debt ratio= long term debt/ capital employed or net assets

Capital employed= long term debt + shareholders’ funds

Net assets= non- fictitious assets- current liabilities

1. Proprietary Ratio

The proprietary ratio is another type of solvency ratios and is also known as the equity ratios. The relationship between the proprietor’s funds, i.e. the funds of all the stakeholders and the net assets. It also shows a comparison between the funds of the owners and the total capital.

Proprietary ratio= shareholders’ funds/ capital employed (net assets)

1. Interest Coverage Ratio

The cost of the debts is known as the interest. Debentures, loans, deposits etc., all have an interest cost. The security of the interest payable on the long term debt is measured by this ratio. It shows the comparison between the profits of the company and the interest paid on the debts.

Formula:

Interest Coverage Ratio= net profit before interest and tax/ interest on long term debts.

Must read: Liquidity Ratios