The Solvency Ratio is one of the ratios used to assess a company’s financial health. This ratio is commonly used by investors before investing in a company, creditors before making loans and insurance customers to ensure that the company can pay coverage when insured risks happen to customers.
The solvency ratio is used to see a company’s ability to pay its obligations, both short term and long term obligations. By knowing the solvency ratio of a company, you can make investment decisions, provide credit and choose insurance companies better.
In this article, we will discuss solvency ratios, their definitions, types, calculation formulas and examples that can help you understand solvency ratios better.
What is meant by Solvency Ratio?
The Solvency Ratio is understood as one of the financial ratios used by investors, creditors, insurance customers and even company management to assess a company’s ability to settle all of its obligations. These obligations can be in the form of long-term obligations, such as mortgage debt, bonds and long-term notes, or short-term obligations, such as trade payables, dividends, fees payable, notes payable and many more.
Types of Solvency Ratios
There are several types of solvency ratios that are commonly used, including:
1. Debt to Equity Ratio
Debt Equity Ratio is a ratio that measures how much a company’s liabilities are towards its own capital. This ratio shows how much the company’s liability is to the capital owned by the company owner (equity).
The Debt Equity Ratio formula is as follows:
Debt Equity Ratio = Total Liabilities / Total Equity
Total Liabilities are the total liabilities of the company, including short term liabilities (short term debt) and long term liabilities (long term debt). Total Equity is the total capital owned by the owner of the company, including share capital and retained earnings.
A high Debt Equity Ratio indicates that the company has a high level of liability to its own capital. This can be interpreted that companies use loans more than their own capital to carry out their activities. Conversely, a low Debt Equity Ratio indicates that the company uses more of its own capital than loans to carry out its activities.
2. Debt to Asset Ratio
Debt to Asset Ratio is a ratio that measures how much a company’s liabilities are to its total assets. This ratio shows how much the company’s liabilities are towards its assets, including current assets (such as cash and receivables) and non-current assets (such as land and buildings).
The Debt to Asset Ratio formula is as follows:
Debt to Asset Ratio = Total Liabilities / Total Assets
Total Liabilities are the total liabilities of the company, including short term liabilities (short term debt) and long term liabilities (long term debt). Total Assets is the total assets owned by the company, including current assets and non-current assets.
A high Debt to Asset Ratio indicates that a company has a high level of liability for its assets. This can be interpreted that companies use loans more than their own capital to carry out their activities. Conversely, a low Debt to Asset Ratio indicates that the company uses more of its own capital than loans to carry out its activities.
3. Time Interested Earned Ratio
Time Interest Earned Ratio is the ratio used to measure a company’s ability to pay its short term obligations (short term debt). This ratio shows how much the company’s ability to pay its short-term obligations using operating profits.
The Time Interest Earned Ratio formula is as follows:
Time Interest Earned Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expense
EBIT is profit before tax and interest earned by the company from its business activities. Meanwhile, Interest Expense is the interest that must be paid by the company to parties that provide loans to the company.
A high Time Interest Earned Ratio indicates that the company has a good ability to pay its short term obligations using operating profit. Conversely, a low Time Interest Earned Ratio indicates that the company has a poor ability to pay its short-term obligations.
It should be remembered that the Time Interest Earned Ratio only measures a company’s ability to pay its short term obligations, not including long term liabilities. Therefore, it is also necessary to pay attention to other ratios that measure a company’s ability to pay long-term obligations, such as the Debt to Equity Ratio or the Debt to Asset Ratio.
How to Calculate Solvency Ratio
To calculate the solvency ratio using the three types of ratios above, the examples are as follows:
Example of calculating the Debt to Equity Ratio
If a company has a total liability of Rp. 500 million and a total owner’s capital of Rp. 300 million, then the company’s Debt to Equity Ratio is as follows:
Debt to Equity Ratio = $ 500 million / $ 300 million = 1.67
Thus, the company’s Debt to Equity Ratio is 1.67. That is, the company has a liability level of 1.67 times the owner’s capital.
Example of calculating the Debt to Asset Ratio
A company has a total debt of $ 100,000 and total assets of $ 200,000, then the Debt to Asset Ratio is:
Debt to Asset Ratio = $100,000 / $200,000 = 0.5
This means that the company has a debt of 50% of its total assets.
Example of Calculation of Time Interest Earned Ratio
If a company earns profit before tax and interest (EBIT) of $ 200 million per year and has interest payable of $ 50 million per year, then the company’s Time Interest Earned Ratio is as follows:
Time Interest Earned Ratio = $ 200 million / $ 50 million = 4
Thus, the company’s Time Interest Earned Ratio is 4. This means that the company has a good ability to pay its short-term obligations using operating profit, because its operating profit (EBIT) is 4 times greater than the interest to be paid.
Benefits of Knowing the Solvency Ratio of a Company
Knowing the solvency ratio of a company can provide information about the company’s ability to meet its financial obligations. The solvency ratio shows how much a company’s ability to meet its long-term obligations using long-term funding sources, such as total assets and capital used. And short-term liabilities use short-term funding sources, such as EBIT or earnings before interest and taxes.
Knowing the solvency ratio of a company can provide important information for investors, creditors, and other parties with an interest in the company’s finances. Investors and creditors can use this solvency ratio as a factor in evaluating the investment or credit risk that will be made. In addition, knowing the solvency ratio of a company can also help in making business decisions, such as determining the financing strategy and managing the company’s finances.
Conclusion
So, the solvency ratio is one of the profit ratios used to assess the financial health of a company based on its ability to pay short-term and long-term obligations. Solvability ratios can be used by investors, creditors and other interested parties to determine the financial condition of a company. They can use various types of solvency ratios, such as the Debt to Equity Ratio, Debt to Asset Ratio and also the Time Interest Earned Ratio.
Knowing the company’s solvency ratio can better assist these parties in making investment decisions, extending credit and others. Even for internal companies, knowing the solvency ratio will help them make wiser decisions related to financing and company finances.
