Unit 2: Solvency Ratios

Unit Learning Outcomes:

 Know the different solvency ratios
 compute solvency ratio given a company’s financial statement
 Interpret solvency ratios

Thinking activity

1. Assume that your parents are selling commercial land. Due to this covid-19
problem, to sell the said commercial land is quite challenging.
2. Two of your family friends ask if they can purchase the commercial land on credit.
3. Your parents are willing to dispose of the land as long as the buyer can pay at least
30% of the price then pay the remaining balance in 5 years.
4. Since both potential buyers are your family friends, your parents ask everyone in the
family to consider who will be the right buyer.
5. As part of the family, you must contribute ideas. What will be the factors that you will
consider in order to find the right buyer? Share at least two factors and explain them.
 Solvency refers to the capacity of a company to pay its long-term liability when it
becomes due. The solvency ratios are used to measure a company's capacity to pay its
long-term debt apart from its regular obligations.

Types of solvency ratios:

EBIT
1. ¿ Interest Earned Ratio=
Interest Expenses

Net Profit Before Interest

2. Debt −Service Co verage Ratio=
Payment on Principal ∧Interest

Total LIabilities
3. Debt Ratio=
Total Assets

4. Equity Ratio=
'
Owne r s Equity
Total Assets

5. Debt −¿ Equity Ratio=

Total Debt
'
Owne r s Equity

6. Debt −¿ Capitalization Ratio= Total Debt + Equity

Total Debt

Solvency ratios are key metrics used to measure a company's ability to meet its
long-term debt obligation and are used often by prospective business lenders. Solvency ratio
indicates whether a company's cash flow is sufficient to meet its long-term, and measure the
company's financial health.
 A solvency ratio measures a firm's actual cash flow, rather than net income.
 It assesses a company's payment ability for its long-term debt and the
interest on that debt.
 It varies from industry to industry; hence, it should be compared to two
different companies in the same industry.
Let's use Fidas' Merchandising financial statements to analyze the different solvency ratios.
Refer to page 57.

Types of Solvency Ratios

1. Times interest earned ratio or interest coverage ratio

 It measures how many times a company can cover its current interest
payment with its available earnings. In other words, it measures the margin
of safety a company has for paying interest on its debt during a given period.
 Higher ratio is favorable. If there is a 21.5 or below ratio, it may indicate that a
company will have difficulty meeting the interest on its debts.

EBIT
¿ Interest Earned Ratio=
Interest Expenses

*EBIT = Earnings before Interest and Taxes

Example:
2021 2020 2019

₱ 292.0 247.4 287.6

¿ Interest Earned Ratio= =3.2 =8.1 =11.5
90.0 30.5 25.0

Fidas Merchandising interest coverage ratio is 11.5 times in 2019, 8.1 times in 2020,
and 3.2 times in 2021. The decrease in the number of times may be due to increasing
interest payments from large amounts of loans.

2. Debt Ratio

 It is otherwise known as the debt to asset ratio. It measures a company's leverage

and indicates how much of the company is funded by debt versus assets, and
therefore, its ability to pay off its debt with its available assets. A higher ratio
above1.0 indicates that a company is significantly founded by debt and may have
difficulty meeting its obligations. Thus; lower ratio or below 0.5 or 50% is better.
 The Debt Ratio is calculated as follows:

Total Liabilities
Debt Ratio=
Total Assets

Example:

2021 2020 2019

2 ,374.3 997.2 980.7

Debt Ratio= =91.6 % =81.6 % =80.2 %
2 ,592.2 1, 221.6 1, 223.1

Since 2019, Fidas Merchandising has been heavily financed by creditors. In 2019,
80.2% of the assets were financed by creditors. Then went slightly higher in 2020 as debt
ratio was 81.6%. In 2021, it even increased to 91.6%. The company is highly leveraged and
this is risky because most of its assets are owned by the creditors.
3. Equity Ratio
 The equity ratio is a financial metric that measures the amount of assets that are
financed by the owner's investment by comparing the total equity in the company to
the total assets.
 In general, higher equity ratios are favorable for companies. Higher investments level
by shareholders show potential investors that the company is worth investing in since
a company is more sustainable and less risky to land future loans. The equity ratio of
about 0.5, or 50% and above is considered a good equity ratio.
 The equity ratio is calculated as follows:

Total Equity
Equity Ratio=
Total Assets

Example
2021 2020 2019
217.9 224.4 242.4
Equity Ratio= =8.4 =18.4 =19.8
2,592.2 1,221.6 1 ,223.1

Fidas Merchandising’s equity ratio is 19.8% for 2019. This slightly went down
to18.4% in 2020 then went down further to 8.4% in 2021. These rates are critically low for
the company as these indicate dependence on creditors for sources of funds. For 2021, the
owner only own 8.4% of company assets while the creditors own 91.6%. For 2020 and 2019,
the owner owns 18.4% and 19.8% respectively while the creditors own 81.6% and 80.2%
respectively. This is way below the optimal fair ratio.

4. Debt to Equity Ratio

Debt to equity ratio, otherwise known as financial leverage ratio, measures the
financing provided by the creditors against those provided by the owner. This measures the
extent of the borrowed funds as compared to the investment by the owner. The optimal fair
ratio is 1 or 100%. This means that liabilities are equal to owner’s equity. The higher the ratio
the higher the risk as interest payments on liabilities are enormous. Hence, a lower ratio is
favorable.

Total Liabilities
Debt ¿ equity=
Total Equity

Example
2021 2020 2019

₱ 2,374.3 ₱ 997.2 ₱ 980.7

Debt ¿ Equity Ratio =10.9 =4.4 =4.0
₱ 217.9 ₱ 224.4 ₱ 242.4

The debt to equity ratio is increasing through the year. In 2019, debt equity ratio was
4:1 which meant that for every ₱ 1 financed by the owner in the assets of the business, ₱ 4
was financed by the creditors. The following year showed as slightly higher ratio that for
every heavily funded the assets of the company that for every ₱ 1 funded by the owner, the
creditors funded ₱ 10.90. This is very unfavorable since the company will definitely pay huge
interest for the use of creditor funds in the business. This is evident as the interest expense
surged in 2021 which can be seen in the income statement.

Let’s practice more solving solvency or stability ratios. Using the comparative
statements of financial position of total Pretty Beauty salon as well as its comparative
statements of comprehensive income (refer to pages 61-62), calculate and the interpret
company’s solvency ratios such as:

1. Times Interest earned ratio

2. Debt- service coverage ratio
3. Debt ratio
4. Equity ratio
5. Debt-to- Equity ratio
6. Debt to capitalization ratio

Solution

Net Profit Before Interest ∧Income taxes

1. Times Interest Earned Ratio =
Annual Interest Expense

Year Times Interest Earned Ratio

2020 ₱ 561 025.00
= 53 times
₱ 10 500.00
2019 Not applicable
The times interest earned ration cannot be
computed for 2019 since the interest
expense for the year is zero
Note: High times interest earned ratio assures long-term creditors that interests can be
settled by the company.

Net Profit before Interest

3. Debt-Service Coverage Ratio=
Payments on Principal∧Interest

Year Debt-Service Coverage Ratio

2020 ₱ 561 025.00
=9׿
₱ ( 400,000.00−350,000.00 ) +10,500.00
2019 Not applicable
No interest and principal payments

total Liabilities
4. Debt Ratio =
total Assets

Year Debt ratio

 2020 ₱ 475,000.00
=37.68 %
₱ 1,260,525.00
2019 ₱ 500,000.00
=40.23 %
₱ 1,242,800.00

'
Owne r s Equity
5. Equity Ratio =
total Assets

Year Equity Ratio

2020 ₱ 785,525 .00
= 62.32%
₱ 1,260,525. .00
2019 ₱ 742,800 .00
=59.77 %
₱ 1,242,800 .00

Total Debt
6. Debt- to – Equity ratio = '
Owne r sEquity

Year Debt- to – Equity Ratio

2020 ₱ 475,000.00
=60.47 %
₱ 785,525.00
2019 ₱ 500,000 .00
=67.31 %
₱ 742,800 .00

Note: The Company is highly leveraged with high debt-to-equity ratio. The ideal ratio
is 50:50

Total Debt
7. Debt- to – Capitalization Ratio=
Total Debt + Equity

Year Debt-to-Capitalization ratio

2020 ₱ 475,000.00
=0.38 :1.00
₱ ( 475,000 .00+785,525.00)
2019 ₱ 500,000 .00
=0.40:1.00
₱ ( 500,000.00+742,800.00)