Solvency ratios are financial metrics that assess a company's ability to service its long-term debt and interest. Solvency ratios are also known as financial leverage ratios that compare the company's debt to its assets, equity, or earnings. In other words, how many times the company can cover its debt given its assets, equity, or earnings. Unlike liquidity ratios, solvency ratios have a longer term outlook.
Solvency ratios vary from industry to industry, making them less effective when comparing companies between different industries. However, it can be used to highlight anomalies between peers within the same sector.
The four common solvency ratios are Equity Ratio, Debt-to-Equity Ratio, Debt-to-Assets Ratio, and Interest Coverage Ratio.
Also known as Equity-to-Assets Ratio, shows how much a company is funded by equity as opposed to debt. A higher Equity Ratio indicates that a larger portion of the company's assets is funded by shareholders' equity rather than debt, which is favorable for the company's financial health. A lower Equity Ratio suggests that the company relies on debt to finance its business. The Equity Ratio formula is:
Equity Ratio = Shareholders' Equity / Total Assets
Debt-to-Equity Ratio (D/E) indicates how much of a company's equity is financed by creditors. Debt-to-Equity Ratio also shows how much of the company's debt can be covered should it liquidates its equity. A lower Debt-to-Equity Ratio is favorable for the company's financial health. The formula for Debt-to-Equity Ratio is:
Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
The Debt-to-Assets Ratios assesses a company's total debt to its total assets. It shows how leveraged a company is and is an indication of how much the company is funded by debt relative to its assets. A lower Debt-to-Assets Ratio is favorable for the company's financial health. The formula for Debt-to-Assets Ratio is:
Debt-to-Assets Ratio = Total Debt / Total Assets
Interest Coverage Ratio
This ratio evaluates how many times a company can cover its current interest payments with its available earnings. It represents the company's safety margin for paying its interest on debt over a specific period. A higher Interest Coverage Ratio indicates a greater capacity to service its interest obligation. The formula for Interest Coverage Ratio is:
Interest Coverage Ratio = EBIT / Interest Expense