Solvency: Meaning and Important Ratios

Meaning of Solvency:

Solvency generally refers to the capacity or ability of the business to meet its short-term and long-term obligations. The capacity to pay off the current debts of the company is represented by the liquidity ratios. Liquidity ratios will explain the short-term solvency or financial position of the business. Hence, the solvency refers to the ability to meet the long-term obligations of the business and the ratios used to assess the long-term solvency or financial position of the business is called as solvency ratios.

Generally, shareholders, debenture holders, and long-term creditors like financial institutions are interested in these ratios. These ratios are also used to analyze the capital structure of the company. They indicate the pattern of financing, whether the long-term requirements have been met out of long-term funds or not.

Principal Solvency Ratios:

Some of the important solvency ratios are as follows:

Debt- Equity Ratio, Proprietary Ratios, Debt Service Ratio or Interest coverage Ratio, etc.

Debt-Equity Ratio:

Debt-equity Ratio relates all external liabilities to Owners recorded claims. It is also known as External-Internal Equity ratio. It is determined to measure the firms obligations to creditors in relation to the funds invested by owners.

Components:

The term external equities refers to total outside liabilities, and internal equities include all claims of preference shareholders, equity shareholders such as share capital and reserves and surplus.

Outside liabilities include all debts, whether long-term or short-term, or in the form of mortgage, bills or debentures. But when used as a long-term financial ratio, only long-term debts like debentures, mortgage loans, term loans, etc., are to be considered.

Example 1:

From the following figures, compute the Debt- Equity ratio:

Solution:

Internal Equities = Shareholders Funds = Rs.21, 00,000(1st four item)

External Equities = Creditors Funds = Rs.12, 00,000(Remaining items)

This means that the external debts are equal to about 57% of shareholders funds. This indicates that even if the value of assets decreases by 43%, the creditors will be paid in full. Normally this ratio is expressed as a proportion. It means that for every four rupees worth of the creditors investment, the shareholders have invested seven rupees worth.

Significance:

This ratio enables one to ascertain the proportion of shareholders stake in the business. Excessive liabilities tend to cause insolvency. The ratio indicates the extent of assets cushion available to creditors on liquidation.

However, the interpretation of the ratio depends upon the financial and business policy of the company. While the owners try to gain the benefits of maintaining control with limited investment, the creditors would insist that the owners investment is more in the business.

Hence, an acceptable norm for this ratio is 1:1 (i.e., possessing equal interest in the business by both creditors and owners). Theoretically, if the owners interest is greater than that of creditors, the financial position is highly solvent.

In the analysis of the long-term financial position of business, it enjoys the same importance as the current ratio does in the short-term financial position.

Proprietary Ratio:

This is a variant of the debt -equity ratio. This ratio relates the shareholders funds to total assets. It is calculated by dividing the shareholders funds by the total tangible assets. This ratio indicates the long-term or the future solvency position of the business.

Components:

Shareholders funds include preference and equity share capital plus all reserves and surplus items. Total assets include all assets including goodwill. Some authors exclude it from total assets.

In that case, the total shareholders funds are to be divided by total tangible assets. As the total assets are always equal to total liabilities, the total liabilities may also be used as the denominator in the above formula.

Example 2:

Using the data given in Example 1, compute Proprietary Ratio:

Shareholders Funds = Rs.21, 00,000

Total Liabilities (Resources) = Rs.33, 00,000

Interpretation:

This ratio explains that out of every Re.1 employed in the business, shareholders contribution is about 64 paise or 64% of total resources used.

The difference between this ratio and 100 per cent represents the ratio of other liabilities to total assets or total liabilities. Accordingly, the creditors contribution would be the remaining 36 paise.

Significance:

This ratio throws light on the general financial strength of the company. It has come to be regarded as a test of the soundness of the capital structure. It is of great importance to creditors since it enables them to find out the proportion of shareholders funds in the total assets used in the business. While a high proprietary ratio indicates a relatively secure position to the creditors in the event of liquidation, a low proprietary ratio will include greater risk to the creditors.

The Debt-Equity Ratio or Proprietary Ratio may be analyzed further into the following ratios:

(a) Ratio of Fixed Assets to Shareholders Funds

(b) Ratio of Current Assets to Shareholders Funds

Fixed Assets to Shareholders Funds Ratio:

This ratio establishes the relationship between fixed assets and shareholders funds. The purpose of this ratio is to indicate the percentage of Owners Funds invested in fixed assets. The fixed assets are considered at their depreciated book values and the proprietors funds consist of all the items of internal equities such as preference shareholders claims and equity shareholders claims, viz., equity share capital and reserves and surplus. This ratio may be expressed as a percentage or as a proportion.

Example 3:

Suppose the depreciated book value of fixed assets is Rs.36, 000 and proprietors funds are Rs.48, 000, the relevant ratio will be as follows:

From the above computation it can be ascertained that 75 percent of the shareholders funds have been invested in Fixed Assets and 25 percent have been used for working capital purpose.

The standard for this ratio may vary from business to business and it may be taken as standard at 65% for industrial undertakings. If the ratio is more than one, it may mean that creditors obligations have been used to acquire a part of the fixed assets.

Current Assets to Proprietors Funds Ratio:

This ratio establishes the relationship between current assets and shareholders funds. The purpose of the ratio is to indicate the percentage of shareholders funds invested in current assets. This may be expressed as a percentage or as a proportion. It is calculated as follows:

Example 4:

Suppose the value of current assets is Rs.36, 000 and the proprietors funds are Rs. 1,80,000, the relevant ratio would be

This may also be expressed as 20% or 0.2:1. it means that 20% of proprietors funds have been invested in current assets. Different industries have different norms and therefore, this ratio should be studied carefully taking the history of individual concern into consideration before relying too much on this ratio. For a meaningful analysis, this ratio should be read along with the results given by the Fixed Assets to Proprietors Funds Ratio.

Debt Service Ratio:

This ratio relates fixed interest charges to the income earned by the business. It is also known as Interest Coverage Ratio. It indicates whether the business has earned sufficient profits to pay periodically the interest charges.

Example 5:

The operating profit of Excel Ltd. after charging interest and tax is a sum of Rs. 1, 24,000. The amount of interest charged is Rs.25, 000 and the provision made for taxation has been Rs. 1, 24,000 being 50% of total profits. Calculate the Interest Coverage Ratio.

Significance:

The Interest Coverage Ratio is very important from the lenders point of view. It gives an idea of the number of times that the fixed interest charges are covered by earnings.

It is an index of financial strength of an enterprise and indicates the margin of safety of the long-term creditors. The standard for this ratio for an industrial company is that the interest charges should be covered by six to seven times.

A high ratio assures the lender a regular and periodical interest income. But the weakness of the ratio may create some problems to the financial manager in raising funds from debt sources.

(a) Total Investments to long-term liabilities:

This ratio compares share capital to loan capital. Generally, a high proportion of long-term liabilities are risky to any company, which, this ratio enables one to find out.

(b) Current liabilities to Proprietors Funds:

This ratio compares current liabilities to proprietors funds. This ratio is an index for measuring the amount of funds supplied by proprietors as against those supplied by short-term creditors in the financing of the company.

(c) Reserve to Equity Capital Ratio:

This ratio compares reserves to equity capital. It may reveal the companys policy with regard to growth and distribution of dividends. It also indicates the effect of ploughing back of profits on share value.

Computation of Ratios from Financial Statement Information:

Illustration 1:

ABC Ltd. sells goods on cash and credit terms. The following particulars are extracted from their books of accounts for the calendar year 2002:

Note:

(1) It has been assumed that the number of working days in a year is 360.

(2) Information relating to Provision for bad debts and sundry creditors is not relevant for computation.

Illustration 2:

From the following details, calculate the current ratio and acid test ratio:

Note:

Liquid assets = Current assets-stock and prepaid taxes = 1,45,000-77,700 = 67,300.

Liquid liabilities = Current liabilities Bank overdraft and income received in advance

Illustration 3:

The Balance Sheet of Sri Ram Ltd., as on 31.12.2002 is as follows:

Calculate, (a) Current Ratio (b) Liquid Ratio (c) Debt Equity Ratio (d) Capital Gearing Ratio (e) Proprietary Ratio

Illustration 4:

From the following Income Statement of Excel Ltd., compute the Profitability Ratios:

Solution:

Computation of Profitability Ratios:

Note:

(1) Operating Cost = Cost of goods sold + operating expenses

(2) Cost of Goods sold = Opening Stock + Purchases Closing tock

(3) Operating Expenses = Office and administration expenses + Selling & Distribution exps.

(d) Operating Profit Ratio = 1 Operating Cost Ratio

= 1 80% = 20%

Non-operating expenses = Loss on sale of assets + Finance expenses.

1. discuss the importance of solvency ratio.

2. Based on your discussion you are required to address the following;

a. What do you understand from the concept of solvency?

b. Why solvency is important for businesses in a financial environment.

c. Assume an example to calculate the solvency ratios based on its formula.