Ratio Analysis – Part II: Solvency Ratios

Financial statement analysis is much more than memorizing formulas—it's about unraveling the story behind the numbers. When we look at solvency ratios, we're concerned with the long-term health of an enterprise:
Can it honor its debts not just today, but year after year?
That's the question investors and creditors ask before they commit their resources. Let's walk through the core solvency ratios that every commerce student, analyst, and manager must understand.

Long-Term Solvency Ratios

Solvency ratios assess whether a business has the financial muscle to pay off its long-term obligations. Each ratio offers a unique lens like some focus on the balance between borrowed funds and owner's equity, others on the safety margin provided by profits.

a. Debt-Equity Ratio

Formula:
\[ \text{Debt-Equity Ratio} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}} \]

This ratio reveals how much of the company's assets are financed through debt compared to equity. A high ratio indicates heavy reliance on borrowed funds, while a low ratio signals conservative financing.

• Significance for Investors: High debt-equity can mean higher risk but sometimes higher returns. Investors weigh this ratio to judge the company's financial leverage.
• Significance for Creditors: Creditors prefer a lower debt-equity ratio, as it suggests greater security. A soaring ratio may make them hesitant to lend further.

Example:

Debt-Equity Ratio = 10,00,000 / 5,00,000 = 2:1
Interpretation: For every ₹1 of equity, the company has ₹2 of debt, this high ratio may signal risk if earnings are unstable.

A very high debt-equity ratio means the firm is highly leveraged, which could threaten solvency if profits falter.

b. Proprietary Ratio

Formula:
\[ \text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}} \]

This ratio shows the proportion of total assets financed by owners. It's a direct measure of the company's financial strength.

• Significance for Investors: The higher the ratio, the more stable the company is seen, owners have a larger stake.
• Significance for Creditors: A low proprietary ratio warns creditors the business relies heavily on external funds.

Example:

Proprietary Ratio = 4,00,000 / 10,00,000 = 0.4
Interpretation: Owners finance 40% of assets, a moderate position, but creditors will want to see this number above 0.5 for comfort.

c. Capital Gearing Ratio

Formula:
\[ \text{Capital Gearing Ratio} = \frac{\text{Fixed Cost Capital}}{\text{Equity Shareholders’ Funds}} \]

Fixed cost capital includes preference shares and debentures. This ratio judges the balance between fixed returns and variable returns in capital structure.

• Significance for Investors: High gearing means a greater portion of funds earns fixed returns, which may limit profits for equity holders if earnings rise.
• Significance for Creditors: Heavy gearing increases fixed financial commitments, adding risk in lean years.

Example:

Capital Gearing Ratio = (3,00,000 + 1,00,000) / 2,00,000 = 4,00,000 / 2,00,000 = 2:1
Interpretation: Fixed cost capital is twice the equity, high gearing. Equity holders bear more risk, but also enjoy greater upside if profits surge.

d. Interest Coverage Ratio

Formula:
\[ \text{Interest Coverage Ratio} = \frac{\text{Earnings Before Interest and Tax (EBIT)}}{\text{Interest Expense}} \]

This ratio measures how comfortably earnings cover interest costs. It's a key indicator for lenders and bondholders.

• Significance for Investors: A high ratio means interest obligations are easily met, reducing risk.
• Significance for Creditors: Low coverage raises alarms, if earnings dip, interest payments might be missed.

Example:

Interest Coverage Ratio = 6,00,000 / 1,50,000 = 4 times
Interpretation: The company earns enough to pay interest four times over, creditors feel secure.

Example

• "A very high debt-equity ratio means what?" It signals that the company is highly leveraged. Such firms face greater financial risk, especially in periods of low profit, because debt repayments remain obligatory while profits fluctuate.
• "Why is the proprietary ratio important for creditors?" A higher proprietary ratio means owners have invested more, providing a cushion for creditors against potential losses.
• "What does a low interest coverage ratio indicate?" It shows the company may struggle to meet interest payments, a red flag for lenders considering new loans.

Key Solvency Ratios

When you analyze a company's solvency ratios, ask what those numbers reveal about the firm's financial resilience. Is the business built for the long haul, or does it wobble on a precarious stack of debt? That's what separates a good analyst from a mere calculator.