Solvency ratios represent at attempt to assess the organization's ability to meet its payment obligations over a longer period of time, such as the next 5 years. Some of these ratios are often referred to as coverage ratios. These ratios emphasize cash payments that must be made every year to avoid default. Such payments include interest and principal payments on loans.
The total debt to equity ratio is a generic ratio looking at long-term solvency. If this ratio is high, creditors are supplying a substantial portion of all resources used by the organization. This in turn makes it more difficult for the organization to borrow further, if it were to become necessary.
The most common solvency ratios
- 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 is used than investor financing
- Equity ratio
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.
- Debt ratio
Debt ratio is a solvency ratio that measures a firm's total liabilities as a percentage of its total assets. In a sense, this 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. 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.
Types of financial ratios
- liquidity ratios
- solvency ratios
- activity ratios
- profitability ratios
- operations ratios
Profitability ratios or incomes ratios
The operating efficiency of a firm and its ability to ensure adequate return to its shareholders are reflected in the profits earned by it. Therefore, the firm has to earn reasonable profits so as to survive and grow. Firms which fail to make reasonable profits have no future. Profits earned in relation to sales give the indication that the firm is able to meet all operating expenses and also produce a surplus. In order to judge the efficiency of management with respect to production and sales, profitability ratios are calculated in relation to sales. These are:
- Gross profit ratio
- Net profit
- Operating profit
- Operating ratio
- Expenses ratio
- Return on Investment or return on capital employed
- return on shareholder's equity
- Return on equity or earnings per share
- C. Jones, S.A. Finkler, C.T. Kovner 2012, p.116
- F.I. Lessambo 2018, p.375-376
- R.S. Schmidgall 2003, p.79
- S.K. Singh, S. Gupta 2016, p.156
- Jones C., Finkler S.A., Kovner C.T. (2012), Financial Management for Nurse Managers and Executives "Elsevier Health Publishing"
- Lessambo F.I. (2018), Auditing, Assurance Services, and Forensics: A Comprehensive Approach "Springer"
- Schmidgall R.S. (2003), Superintendent's Handbook of Financial Management "John Wiley & Sons"
- Singh S.K.,Gupta S. (2016), Entrepreneurship "SBPD Publications"
Author: Natalia Talarek