SUDIP CHAKRABORTY
SOLVENCY RATIOS
The solvency ratio is calculated from the components of the balance sheet and income statement elements. Solvency ratios help in determining whether the organization is able to repay its long-term debt. It is very important for the investors to know about this ratio as it helps in knowing about the solvency of a company or an organization.
Let us see in detail the various types of solvency ratios.
1. Debt to equity ratio
Debt to equity is one of the most used debt solvency ratios. It is also represented as the D/E ratio. Debt to equity ratio is calculated by dividing a company’s total liabilities with the shareholder’s equity. These values are obtained from the balance sheet of the company’s financial statements.
It is an important metric that is used to evaluate a company’s financial leverage. This ratio helps understand if the shareholder’s equity has the ability to cover all the debts in case the business is experiencing a rough time.
It is represented as
Debt to equity ratio = Long-term debt / shareholder’s funds
Or
Debt to equity ratio = total liabilities / shareholders’ equity
A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the company is using debt for fuelling its growth. It also indicates lower solvency of the business.
2. Debt Ratio
calculated by taking the total liabilities and dividing it by total capital. If the debt ratio is higher, it represents the company is riskier.
The debt ratio is a financial ratio that is used in measuring a company’s financial leverage. It is
The long-term debts include bank loans, bonds payable, notes payable etc.
The debt ratio is represented as
Debt Ratio = Long Term Debt / Capital or Debt Ratio = Long Term Debt / Net Assets
Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt about a firm’s long-term stability. Trading on equity is possible with a higher ratio of debt to capital which helps generate more income for the shareholders of the company.
3. Proprietary Ratio or Equity Ratio
Proprietary ratios is also known as equity ratio. It establishes a relationship between the proprietor's funds and the net assets or capital.
It is expressed as
Equity Ratio = Shareholder’s funds / Capital or Shareholder’s funds / Total Assets
4. Interest Coverage Ratio
The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding debt obligations. It is calculated by dividing the company’s EBIT (Earnings before interest and taxes) by the interest payment due on debts for the accounting period.
It is represented as
Interest coverage ratio = EBIT / interest on long term debt
Where EBIT = Earnings before interest and taxes or Net Profit before interest and tax.
A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates a debt burden on the business.
ACTIVITY RATIOS
The role of activity ratio or turnover ratio is in the evaluation of the efficiency of a business by careful analysis of the inventories, fixed assets and accounts receivables.
Let us discuss the types of activity ratios.
Types of Activity Ratios
- Stock Turnover ratio or Inventory Turnover Ratio
- Debtors' Turnover ratio or Accounts Receivable Turnover Ratio
- Creditors Turnover ratio or Accounts Payable Turnover Ratio
- Working Capital turnover ratio.
- Investment Turnover Ratio
Stock Turnover Ratio
This is one of the most important turnover ratios which highlights the relationship between the inventory or stock in the business and the cost of the goods sold. It shows how fast the inventory gets cleared in an accounting period or in other words, the number of times the inventory or the stock gets sold or consumed. For this reason, it is also known as the inventory turnover ratio.
It is calculated by the following formula
Stock Turnover Ratio = Cost of Goods Sold / Average Inventory
A high stock turnover ratio is indicative of fast-moving goods in a company while a low stock turnover ratio indicates that goods are not getting sold and are being stored at warehouses for an extended period of time.
Debtor Turnover Ratio
This ratio is an important indicator of a company which shows how well a company is able to provide credit facilities to its customers and at the same time is also able to recover the due amount within the payment period.
It is also known as the accounts receivable turnover ratio as the payments for credit sales that will be received in the future are known as accounts receivables.
The formula for calculating the Debtor Turnover ratio is
Debtor Turnover Ratio = Credit Sales / Average Debtors
A higher ratio indicates that the credit policy of the company is sound, while a lower ratio shows a weak credit policy.
Creditors Turnover Ratio
The creditors turnover ratio is a measure of the capability of the company to pay off the amount for credit purchases successfully in an accounting period.
It shows the number of times the account payables are cleared by the company in an accounting period. For this reason, it is also known as the Accounts payable turnover ratio.
The formula for calculating creditors turnover ratio is
Creditors Turnover ratio = Net Credit Purchases / Average Creditors
Where average creditors are also known as average accounts payable.
A high ratio is indicative that a company is able to finance all the credit purchases and vice versa.
Working Capital Turnover Ratio
This ratio is helpful in determining the effectiveness with which a company is able to utilize its working capital for generating sales of its goods.
The formula for calculating the working capital turnover ratio is
Working capital turnover ratio = Sale or Costs of Goods Sold / Working Capital
If a company has a higher level of working capital it shows that the working capital of the business is utilized properly and on the other hand, a low working capital suggests that the business has too many debtors and the inventory is unused.
Investment Turnover Ratio or Net Asset Turnover Ratio
The investment Turnover Ratio is related to the sales taking place in the business and the net assets or the capital employed. It determines the ability of the business to generate sales revenue by the use of the net assets of the business. The ratio is calculated using the following formula
Investment Turnover Ratio = Net Sales/ Capital Employed
Importance of Activity Ratios
Activity ratios are very important indicators of the operating efficiency of the business. It also shows the way in which revenue is generated in a company and the way in which the elements of the balance sheet are utilized for managing the business.
Profitability ratios are a type of accounting ratio that helps in determining the financial performance of a business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations.
