The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and other creditors selling goods on credit. These ratios indicate firm’s ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings.
The following ratios serve the purpose of determining the solvency of the business firm:
- Debt Equity Ratio
- Proprietary Ratio
Debt Equity Ratio
It is also otherwise known as external to internal equity ratio. It is calculated to know the relative claims of outsiders and the owners against the firm’s assets. This ratio establishes the relationship between the outsiders funds and the shareholders funds.
The two basic components of the ratio are outsiders’ funds and shareholders’ funds. The outsiders’ funds include all debts and liabilities to outsiders i.e. debentures, long term loans from financial institutions, etc. Shareholders’ funds mean preference share capital, equity share capital, reserves and surplus and fictitious assets like preliminary expenses.
This ratio indicates the proportion between shareholders’ funds and the long-term borrowed funds. In India, this ratio may be taken as acceptable if it is 2:1. If the debt equity ratio is more than that, it shows a rather risky financial position from the long term point of view.
The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietors. This ratio is very useful to assess the soundness of long term financial position of the firm. It also indicates the extent to which the firm depends upon outsiders for its existence. A low debt equity ratio implies the use of more equity than debt.
It is also known as equity ratio. This ratio establishes the relationship between shareholders’ funds to total assets of the firm. The shareholders’ funds is the sum of equity share capital, preference share capital, reserves and surpluses. Out of this amount, accumulated losses should be deducted. On the other hand, the total assets mean total resources of the concern.
Proprietary ratio throws light on the general financial position of the enterprise. This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets employed in the firm. A high ratio shows that there is safety for creditors of all types. Higher the ratio, the better it is for concern. A ratio below 50% may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses.
Interest Coverage Ratio
This ratio establishes the relationship between Net Profit before Interest and Tax and Interest on long-term debts.
This ratio is very useful to the long term lending agencies like debenture holders and lenders of long term funds as it indicates the number of times the interest on long term funds is covered by profits. A high ratio is considered better for the lenders because it provides higher safety margin.