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Reading Financial Statements with an Analytical Eye 
 
by kmhagen June 10, 2005

Solvency Ratios

Solvency ratios are measures to assess a company’s ability to meet its long-term obligations and thereby remain solvent and avoid bankruptcy. Two general, overall solvency ratios include:

Solvency Ratio = Total Assets / Total Liabilities

and

Solvency Ratio = Net Worth (Total Capital or Equity) / Total Liabilities

These ratios basically tell whether a company owns more than it owes. The higher the ratio, the more solvent the company.

Another ratio that can tell how much a company relies on debt to finance its assets is:

Debt Ratio = Total Debt / Total Assets

Traditionally, both short-term and long-term debts and assets are used in determining this ratio. In general, the lower a company’s reliance on debt to finance its assets, the less risky the company.

The debt to equity ratio is a measure of a company’s leverage – how much financing it has in the form of debt as compared with how much it has invested in the business.

Debt-equity Ratio = Total Liabilities / Total Owners’ Equity, or

Debt-equity Ratio = Long-Term Liabilities / Total Owners’ Equity

In assessing solvency, it is also important to take into consideration the breakdown of a company’s liabilities. Not all liabilities are debt in the form of bank loans or notes payable, for example. There are also accounts payable to vendors, salaries and wages payable, taxes payable, and accrued liabilities, among others. One of the measures of what debt constitutes in terms of total liabilities is:

Indebtedness Ratio = Total Debts / Total Liabilities

In general, a company that is heavy on debt may be better leveraged, but is also less solvent.

The debt repayment terms are another consideration. Short-term debt, payable within one year, may pose a greater burden on cash flow and eventual solvency than long-term debt, which is due beyond one year. A ratio used to quantify this is:

Short-term Debt Ratio or Quality of Debt = Short-term Debt / Total Debt

A lower value for this ratio would indicate less concern for installments coming due within a year.

There are other ratios intended to assess a company’s capacity to cover its debt repayments and financing costs. One of these ratios measures how interest expense is being covered by the net income the company is generating:

Interest expense coverage = Net income before interest and taxes / Interest expense

This ratio is also called Number of Times Interest Earned, and represents how many times the net income generated by the company, without considering interest and taxes, covers the total interest charge. The higher the ratio the more solvent the company.

Another similar ratio often used to measure a company’s capacity to cover its fixed charges is:

Ratio of Earnings to Fixed Charges = Earnings before income tax and fixed charges / Interest expense (including capitalized interest) and amortization of bond discount and issue costs

Capitalized interest is the amount of interest on a loan to finance a project or acquisition of fixed assets, that has been capitalized and included as part of the cost of the project or asset on the balance sheet. You will probably need to see the notes to the financial statements to find this figure.

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