What is a Solvency Ratio?

Solvency Ratios assess a company’s ability to meet its long-term financial

obligations, or more specifically, the repayment of debt principal and interest expense.
When evaluating prospective borrowers and their financial risk, lenders and debt
investors can determine a company’s creditworthiness by using solvency ratios.

Solvency Ratio Definition

Solvency ratios assess the long-term viability of a company – namely if the
financial performance of the company appears sustainable and if operations
are likely to continue into the future.

Liabilities are defined as obligations that represent cash outflows, most

notably debt, which is the most frequent cause of companies becoming
distressed and having to undergo bankruptcy.
When debt is added to a company’s capital structure, a company’s solvency is
put at increased risk.
On the other hand, assets are defined as resources with economic value that
can be turned into cash (e.g. accounts receivable, inventory) or generate cash
(e.g. property, plant & equipment, or “PP&E”).
With that said, for a company to remain solvent, the company must have more
assets than liabilities – otherwise, the burden of the liabilities will eventually
prevent the company from staying afloat.
 Solvency Ratios Formulas
Solvency ratios compare the overall debt load of a company to its assets or
equity, which effectively shows a company’s level of reliance on debt financing
to fund growth and operate.

Debt-to-Equity Ratio (D/E)

The debt-to-equity ratio compares a company’s total debt balance to the total
shareholders’ equity account, which shows the percentage of financing
contributed by creditors as compared to that of equity investors.

 Higher D/E ratios mean a company relies more heavily on debt financing as
opposed equity financing – and therefore, creditors have a more substantial claim
on the company’s assets if it were to be hypothetically liquidated.

 A D/E ratio of 1.0x means that investors (equity) and creditors (debt) have an equal
stake in the company (i.e. the assets on its balance sheet).

 Lower D/E ratios imply the company is more financially stable with less exposure
to solvency risk.
Debt-to-Assets Ratio
The debt-to-assets ratio compares a company’s total debt burden to the value
of its total assets.

This ratio evaluates whether the company has enough assets to satisfy all its
obligations, both short-term and long-term – i.e. the debt-to-assets ratio
estimates how much value in assets would be remaining after all the
company’s liabilities are paid off.

 Lower debt-to-assets ratios mean the company has sufficient assets to cover its debt
obligations.
 A debt-to-assets ratio of 1.0x signifies the company’s assets are equal to its debt –
i.e. the company must sell off all of its assets to pay off its debt liabilities.

 Higher debt-to-assets ratios are often perceived as red flags since the company’s
assets are inadequate to cover its debt obligations. This may imply that the current
debt burden is too much for the company to handle.
Like the debt-to-equity ratio, a lower ratio (<1.0x) is viewed more favorably, as
it indicates the company is stable in terms of its financial health.

Equity Ratio (Debt-to-Assets)

The third solvency ratio we’ll discuss is the equity ratio, which measures the
value of a company’s assets to its total equity amount.

The equity ratio shows the extent to which the company is financed with
equity (e.g. owners’ capital, equity financing) rather than debt.

In other words, if all the liabilities are paid off, the equity ratio is the amount of
remaining asset value left over for shareholders.
 Lower equity ratios are viewed as more favorable since it means that more of the
company is financed with equity, which implies that the company’s earnings and
contributions from equity investors are funding its operations – as opposed to debt
lenders.

 Higher equity ratios signal that more assets were purchased with debt as the source
of capital (i.e. implying the company carries a substantial debt load).

What are Solvency Ratios?

Solvency Ratios are the ratios that are calculated to judge the financial
position of the organization from a long-term solvency point of view.
These ratios measure the firm’s ability to satisfy its long-term obligations
and are closely tracked by investors to understand and appreciate the
ability of the business to meet its long-term liabilities and help them in
decision making for long-term investment of their funds in the business.
 Accordingly, Solvency ratios are calculated for judging the financial
position to ascertain whether the business is financially sound to meet its
long-term commitments.
 Solvency Ratios analyzes the ability of a business to pay its long-term
debt. It is important to note here that the portion of Shareholder’s Funds
(Owner’s Equity) out of the total liabilities determines the Solvency of an
Organization.
 The higher the Shareholder’s Funds compared to other liabilities of
the Organization, the greater the Solvency business enjoys and vice
versa.
List of Solvency Ratios
A list of important Solvency ratios are discussed below, followed by a
Numerical example:
#1 – Long-Term Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of long-term
debt business has undertaken vis-à-vis the Equity and helps in finding
the leverage of the business. Here Long-Term Debt includes long-term
loans, i.e., Debentures or Long-term loans taken from Financial
Institutions, and Equity means Shareholders’ Funds, i.e., Equity Share
Capital, Preference Share Capital and Reserves in the form of Retained
Earnings. The Ratio also helps in identifying how much Long-term debt
business has raise compared to its Equity Contribution.
Solvency Ratio Formula:
Long Term Debt to Equity Ratio= Long Term Debt/ Total Equity
#2 – Total Debt- to- Equity Ratio
This solvency ratio formula aims to determine the amount of total debt
(which includes both short-term debt and long-term debt) a business
has undertaken vis-à-vis the Equity and helps in finding the total
leverage of the business. The Ratio helps in identifying how much
business is funded by debt compared to Equity Contribution. In a
nutshell higher, the ratio, higher the leverage, and higher is the risk on
account of a heavy debt obligation (in the form of Interest and Principal
Payments) on the part of the business
Solvency Ratio Formula:
Total Debt to Equity Ratio= Total Debt/ Total Equity
#3 – Debt Ratio
This Ratio aims to determine the proportion of total assets of the
company (which includes both Current Assets and Non-Current
Assets), which are financed by Debt and helps in assessing the total
leverage of the business. The higher the ratio, the higher the leverage
and higher is the financial risk on account of a heavy debt obligation (in
the form of Interest and Principal Payments) on the part of the business
Solvency Ratio Formula:
Debt Ratio= Total Debt/ Total Assets
#4 – Financial Leverage
The Financial Leverage ratio captures the impact of all obligation, both
interest-bearing and non-interest bearing. This Ratio aims to determine
how much of the business assets belong to the Shareholders of the
company rather than the Debt holders /Creditors. Accordingly, if the
majority of the assets are funded by Equity Shareholders, the business
will be less leveraged compared to the majority of the assets funded by
Debt (in that case, the business will be more leveraged). The higher the
ratio, the higher the leverage and higher is the financial risk on account
of heavy debt obligation taken to finance the assets of the business
Solvency Ratio Formula:
Financial Leverage= Total Assets/ Total Equity
#5 – Proprietary Ratio
This ratio establishes the relationship between Shareholders’ funds and
total assets of the business.  It indicates the extent to which
shareholder’s funds have been invested in the assets of the business. The
higher the ratio, the lesser the leverage, and comparatively less is
the financial risk on the part of the business. Conversely, it can be
calculated by taking the inverse of the Financial Leverage Ratio.
Solvency Ratio Formula:
Proprietary Ratio= Total Equity/ Total Assets
Example of Solvency Ratios
Let’s understand the above Ratios with the help of a Numerical example
for better conceptual clarity:
Alpha and Beta are two companies operating in the same line of
business of Leather Shoe Manufacturing, which has furnished
certain details from their Balance Sheet at the end of the year. Let’s
analyze the Solvency of the two businesses based on the same.
Particulars Alpha Company Beta Company

Common Stock (1$ par value) (1) $550000 $500000

Preferred Stock (2) $150000 $200000

Retained Earnings (3) $800000 $700000

Total Equity (1+2+3) $1500000 $1400000

Current Assets (A) $1500000 $1700000

Long Term Assets/ Non Current Assets (B) $1500000 $1200000

Total Assets (A+B) $3000000 $2900000

Short Term Debt (C) $600000 $1000000

Long Term Debt (D) $900000 $500000

Total Debt (C+D) $1500000 $1500000

Now, let’s see the formula and calculation for the Solvency Ratios below:
In the below-given figure, we have done the calculation for various
solvency ratios.
Ratios Alpha Company Beta Company

Long Term Debt/Total Long Term Debt/Total

Long Term Debt to Equity Equity
Equity Ratio =$900000/$1500000 =$500000/$1400000
=0.6 =0.36

Total Debt/Total Equity Total Debt/Total Equity

Total Debt to Equity
=$1500000/$1500000 =$1500000/$1400000
Ratio
=1 =1.07

Total Debt/Total Assets Total Debt/Total Assets

Debt Ratio =$1500000/$3000000 =$1500000/$2900000
=0.5 =0.52
 Ratios Alpha Company Beta Company

Total Assets/Total Equity Total Assets/Total Equity

Financial Leverage =$3000000/$1500000 =$2900000/$1400000
=2 =2.07

Total Equity/Total Assets Total Equity/Total Assets

Proprietary Ratio =$1500000/$3000000 =$1400000/$2900000
=0.5 =0.48
Based on the above Ratios, we can observe a few interesting insights:
 Alpha Company has a higher Long-Term Debt to Equity Ratio compared
to Beta Company but a lower Total Debt to Equity ratio compared to
Beta, which is an indication that Beta Company is using more short-term
debt financing to fund itself and will be more prone to liquidity risks in
case the short-term rates moved adversely.
 Both the companies are having the same level of Total Debt; however,
due to increase equity Contribution, Alpha Company has less financial
Leverage compared to Beta Company