What do Solvency Ratios tell?
Just like liquidity ratios, solvency ratios are a key component when conducting company’s financial analysis. It tells whether the company is capable enough to pay its long-term dues from the cash flow generated.
Long-term liabilities are those debt obligations which are not due to be paid in this year but in the coming years. Both Solvency and liquidity are equally important for a company’s financial health.
Remember, liquidity ratio deals with the short-term debts and solvency ratio deals with the long-term debts. To know more about liquidity ratios, click here.
Solvency Ratio Metrics
Debt to equity ratio = Total Debt/ Total Shareholder’s Equity
This is a very commonly used solvency ratio. It is one of the most important metrics when understanding a company’s financial leverage. Debt-to-equity ratio tells how capable a firm is to cover all of its debts with the shareholder’s equity. A value states that the company is using debt for fuelling its growth. Lower D/E ratio is better as it shows higher solvency of the business.
Interest Coverage Ratio = EBIT / interest payments due on debt
EBIT stands for Earnings before interest and tax. This ratio indicates whether the company can pay interest on the outstanding debt obligations. Higher the interest coverage ratio, more stable the company is to pay the interest related to debts from its earnings.
Imagine two companies, company ABC with an Interest coverage ratio of 1.5 and company XYZ with interest coverage ratio 2.5. In this situation, XYZ is considered to be in a better situation to pay the interest payment of its debt obligation when compared to company ABC. When doing financial analysis, it would be better if the company’s solvency ratios are compared to the those of its competitors in the industry.