Understanding Solvency Ratio
As per J. Betty, “The term accounting ratio is used to describe the significant relationship which exists between figures shown in a balance sheet, in a statement of profit and loss, in the budgetary control system or any part of an accounting organisation.”
The ratio can be expressed in pure form, percentage form, times, and fraction terms. Solvency ratios are the indicators of whether the company will be able to pay its long-term liabilities in the future. There are two solvency ratios discussed here that are proprietary and interest coerage ratios
What is the Interest Coverage Ratio?
The interest coverage ratio expresses the relationship between net profit before interest and taxes and interest on long-term debts. It is expressed in terms of the number of times it shows how much interest can be paid by considering profit. It is also known as the debt service ratio. Interest is a charge on profit; it means interest will be paid before considering the taxes to be paid to the government, and hence it reduces the payment of taxes to the government. Therefore, the net profit before taxes is considered while computing the interest coverage ratio.
What is Proprietary Ratio?
Proprietary ratio expresses the relationship between the proprietor's fund and total assets. It may be expressed either as a pure ratio or as a percentage. It is computed either by the liabilities approach or through the assets approach. The results shown by both approaches remain the same irrespective of the chosen method.
How to Calculate Interest Coverage Ratio?
Interest is charged against profit, and hence net profit before tax, interest and tax is used while computing the Interest Coverage ratio, which is expressed several times. The interest coverage ratio formula is as follows:
Interest Coverage Ratio = Profit before Interest and Taxes /Interest on Long term Debt.
How to Calculate Proprietary Ratio?
There are two methods available to commute proprietary ratio; they are here as under
Liabilities Approach:
Share Capital (equity and preference)+ Reserves and Surpluses
Or
Proprietors fund= Capital employed - Non-current Liabilities
Assets Approach
Non-Current Assets +Working Capital - Non-Current Liabilities
The proprietary ratio formula is expressed as:
Proprietary Ratio = Proprietors funds or shareholders funds or equity/Total Assets
Solved Questions
1. From the following information, compute Proprietary Ratio
Solution:
Shareholders Funds= Share Capital + Reserves and Surplus
=Rs 50000 + Rs 30000= Rs 80000
Total Assets= Current Assets +Non-Current assets
=Rs 100000 + Rs 220000= Rs 320000
Proprietary Ratio= Proprietors funds or shareholders funds or equity/Total Assets
=80000/320000=0.25
2. From the following information, compute Interest Coverage Ratio
Prakash Ltd. has a term loan of Rs 100000. Interest on the loan for the year is Rs 12500, and its profit before interest and tax is Rs 50000.
Solution:
Interest on the loan = Rs 12500
Profit before interest and tax =Rs 50000
Interest Coverage Ratio = Profit before Interest and Taxes /Interest on Long term Debt
=50000/12500= 4 times
Therefore, the interest coverage ratio is 4 times.
3. From the following information, compute Interest Coverage Ratio
Solution:
Computation of net profit before interest and taxes
Interest Coverage Ratio = Profit before Interest and Taxes /Interest on Long term Debt
=782000/72000= 10.86 times
Therefore the interest coverage ratio is 10.86 times.
Conclusion
Ratios are the most widely used tool to interpret the quantitative relationships between two variables of financial statements.
Solvency ratios serve as an important tool to measure whether the firm can meet its future long-term obligations of the business. There are two solvency ratios used by creditors: a proprietary ratio and the interest coverage ratio. The higher the ratio, the higher the confidence of the investors to invest in the firm. It serves as assurance as it gives security to the funds.
FAQs on Solvency Ratios: Meaning and Importance
1. What is the primary difference between the Solvency Ratio and Liquidity Ratio?
Solvency ratios analyze the financial capacity of a company and evaluate its ability to meet long-term obligations. It helps in knowing the company’s ability to operate over a longer horizon. Liquidity ratios, on the other hand, have two main objectives: evaluating a company’s ability to meet short-term liabilities that are due under a year and its ability to liquidate (sell) its assets for raising cash.
2. How is a solvency ratio calculated?
Solvency ratios measure the cash flow of a company. This cash flow includes depreciation and non-cash expenses that are measured against its debt obligations.
Solvency Ratio= (Net Income + Depreciation)/ (All Liabilities)
3. What is the significance of the Interest Coverage Ratio?
Interest coverage ratio serves as important to the stakeholders of the company, that is, debenture holders and the long-term lenders of the organisation. It determines the safety measures of the long-term lenders of the organisations. The ideal interest coverage ratio is 6 to 7 times. It shows how often the profit covers the interest charges before taxes. The higher the ratio, the more the security to the lenders, as their interest amount will be secured.
4. What is the significance of the Proprietary Ratio?
To measure the organisation's financial strength, the proprietary ratio is used. It depicts the fund employed by the proprietor by taking the measure through total assets. The company's creditors use it to determine the safety of funds employed by them in a company. The higher the ratio, the more the creditor's willingness to take risks in the business and the lower the ratio, the creditors express less willingness to invest in the company. Hence the ratio in such cases must be high.
5. Can the interest coverage ratio be negative?
Yes, it may be in a few cases, and it may not be a good indicator to the company as this translates to its current earnings being insufficient to service its outstanding debt. The chances of a company continuing to meet its interest expenses are doubtful, even with an interest coverage ratio below 1.5, especially if it is vulnerable to seasonal or cyclical dips in income. It may lead a company towards insolvency procedures.
