Definition of Solvency Ratios and its types – Solvency Ratios or often called Leverage Ratios are financial ratios that measure a company’s ability to meet its long-term obligations such as interest payments on debt, principal payments of debts and other fixed obligations. Long-term debt is usually defined as a payment obligation that has a maturity of more than one year.
Although the Solvency Ratio and the Liquidity Ratio are both ratios to measure a company’s ability to meet its obligations, both have differences in the period of meeting their obligations.
Where the Solvency Ratio is a ratio that measures the company’s ability to meet its long-term obligations while the liquidity ratio measures the company’s ability to meet its short-term obligations or current liabilities.
Please to also read Cash Ratio definition and its formula.
This Solvency Ratio compares the overall debt burden of a company against its assets or equity. In other words, this ratio shows how much company assets owned by shareholders compared to assets owned by creditors.
If shareholders have more assets, then the company is said to be lacking leverage. But if the creditor has the majority of assets, then the company in question is said to have a high degree of leverage. Solvency Ratio or Leverage Ratio is very helpful for management and investors to understand the level of risk capital structure in the company.
Types of Solvency Ratios or Leverage Ratios
The following below are some of the Solvency Ratios which are often used to measure a company’s ability to meet its long-term obligations.
A. Debt to Equity Ratio
Debt to Equity Ratio is a financial ratio that shows the relative proportion between Equity and Debt used to finance company assets. Debt to Equity Ratio (DER) is calculated by taking total debt obligations (Liabilities) and dividing them by Equity. Following below is the Debt to Equity Ratio (DER) Formula.
Debt to Equity Ratio (DER) = Total Debt / Equity
Read more: Definition of Debt to Equity Ratio (DER) and the Formula.
Debt Ratio is a ratio used to measure how much a company relies on debt to finance its assets. Debt Ratio is calculated by dividing total debt (total liabilities) with total assets owned. This Debt Ratio is often also referred to as the Total Debt to Total Assets Ratio. The following is the debt ratio formula:
Debt Ratio = Total Debt / Total Assets
Read more: Understanding Debt Ratio and Formula.
Times Interest Earned Ratio
Times Interest Earned is a ratio that measures a company’s ability to pay or cover future interest expenses. Times Interest Earned Ratio is also often referred to as Interest Coverage Ratio. The way to calculate it is to divide the profit before tax and interest by the Interest Cost. Following is the Times Interest Earned Ratio formula:
Times Interest Earned Ratio = Profit before tax and interest / Interest Expense
Read more: Understanding Times Interest Earned Ratio and Formula.