Accountancy · Ch 9 — Accounting Ratios
Solvency Ratios
Solvency Ratios
The people who lend money to a business for a long period — banks, financial institutions, debenture holders — care about two things: getting their interest on time, and getting their principal back at maturity. Solvency ratios measure the business’s ability to meet these long-term obligations. They tell us whether the firm is financially stable or dangerously over-borrowed.
The textbook lists five solvency ratios. Each one looks at the relationship between debt and some other financial figure — equity, capital employed, total assets, or earnings.
1. Debt-Equity Ratio
This ratio compares the total long-term debt of the business to the shareholders’ funds (equity). It shows the proportion of funds supplied by creditors versus owners. A high ratio means the business is heavily dependent on borrowed money, which is riskier for lenders.
Debt-Equity Ratio = Long-term Debt / Shareholders' Funds
Long-term Debt includes:
- Debentures
- Long-term loans from banks and financial institutions
- Any other borrowings repayable after 12 months
Shareholders’ Funds includes:
- Equity Share Capital
- Preference Share Capital
- Reserves and Surplus (including Capital Reserve, Securities Premium, General Reserve)
- Less: Accumulated Losses and Fictitious Assets (like Preliminary Expenses, Discount on Issue of Shares/Debentures)
Do not include current liabilities (creditors, bills payable, bank overdraft) in long-term debt. They are short-term and not part of solvency analysis.
Interpretation: A lower ratio (say 1:1 or less) is generally considered safer. A very high ratio (e.g., 3:1 or more) indicates excessive debt and higher financial risk.
2. Debt to Capital Employed Ratio
This ratio expresses long-term debt as a percentage of total capital employed in the business. Capital employed is the total long-term funds available — both owners’ and lenders’.
Debt to Capital Employed Ratio = Long-term Debt / Capital Employed
Capital Employed can be calculated in two ways:
- Equity Approach: Shareholders’ Funds + Long-term Debt
- Asset Approach: Total Assets – Current Liabilities
Both methods give the same figure.
If the question gives you a Balance Sheet, use the asset approach: Total Assets minus Current Liabilities. It’s often quicker.
Interpretation: This ratio tells you what fraction of the firm’s long-term capital comes from debt. A ratio of 0.4 means 40% of capital employed is borrowed. A lower percentage is safer.
3. Proprietary Ratio
This ratio measures the proportion of the firm's capital employed (net assets) that is financed by the owners' funds. It shows the owners' stake in the long-term funds of the business.
Proprietary Ratio = Shareholders' Funds / Capital Employed (net assets)
Capital Employed (net assets) = Shareholders' Funds + Long-term Debt = Total Assets − Current Liabilities. Shareholders' Funds exclude fictitious assets (like Preliminary Expenses).
The textbook's primary definition uses Capital Employed (net assets) as the base, but it also notes the ratio may be computed in relation to total assets instead — both bases are seen in practice, and a worked illustration in this chapter uses the total-assets base. On the capital-employed base, the Debt to Capital Employed Ratio and the Proprietary Ratio always add up to 1 (for example 0.25 + 0.75 = 1), meaning 25% of capital employed is funded by debt and 75% by owners' funds.
Interpretation: A higher ratio indicates a stronger financial position and greater safety for creditors. A very low ratio means the business is running mostly on borrowed money.
4. Total Assets to Debt Ratio
This ratio compares total assets to long-term debt. It shows how many times the assets cover the debt.
Total Assets to Debt Ratio = Total Assets / Long-term Debt
Total Assets here means all assets (including current assets, fixed assets, investments) but excluding fictitious assets.
Interpretation: A higher ratio is better. For example, a ratio of 3:1 means assets are three times the debt, so creditors have a good safety margin. A ratio close to 1:1 is risky.
5. Interest Coverage Ratio
This ratio measures the ability of the business to pay interest on its debt out of its profits. It is also called ‘Debt Service Ratio’.
Interest Coverage Ratio = Profit before Interest and Tax (PBIT) / Interest on Long-term Debt
Profit before Interest and Tax (PBIT) is the net profit before deducting interest expense and income tax. It is also called ‘Operating Profit’ or ‘Earnings before Interest and Tax (EBIT)’.
Interest on Long-term Debt includes interest on debentures, long-term loans, etc. Do not include interest on short-term borrowings (like bank overdraft) unless specified.
A ratio of less than 1 means the business is not earning enough to cover its interest payments — a serious red flag for lenders. …