Solvency Ratio
Table of Contents
Long-Term Solvency
Solvency Ratio assesses the long-term financial condition of the firm. Bankers and creditors are most interested in liquidity. But shareholders, debenture holders, and financial institutions are concerned with the long-term financial prospects.
1. Proprietary Ratio
Proprietary Ratio is the relationship between proprietor’s funds and total assets. Proprietary Ratio indicates the proportion of shareholder’s funds in the total assets. A high proprietary ratio indicates less danger and risk to creditors in the event of winding up.
Formula
Proprietary Ratio = Shareholder’s Funds / Total Assets.
- Shareholders Funds
- Equity share capital, pre-share capital, all Reserves, surplus.
- Total Assets
- All Assets, Goodwill (including)…
- Reminder
- The acceptable norm of the ratio is 1:3.
1,A. Fixed Assets to Proprietor’s Funds Ratio
This indicates the relationship between fixed assets and shareholder funds. The purpose of this ratio is to calculate the percentage of the owner fund invested in fixed assets.
Formula
Fixed Assets to Shareholder’s Fund = Fixed Assets/ Proprietor’s Funds
Fixed assets= fixed assets – Depreciation
- Proprietor’s Fund or shareholder’s Fund or Internal Equities or Net worth
- Equity share capital, Pre-Share Capital, Reserves, Surplus.
- Remember
- If the ratio is greater than 1, it means that the creditor’s obligation has been used to acquire a part of fixed assets.
1,B. Current Assets to Proprietor Fund Ratio
It shows the relationship between the current assets and the shareholder’s fund. The purpose of this ratio is to calculate the percentage of shareholder’s funds invested in current assets.
Formula
Current Assets to Proprietor’s fund = Current Assets / Proprietor’s Fund
2. Capital Gearing Ratio
This ratio is also known as Capitalization or leverage ratio. It is also one of the long term solvency ratios. It is used to analyze the capital structure of the company. The ratio established relationship between fixed interest and dividend bearing funds and equity shareholder’s funds.
Formula
Capital gearing = Long term loans+ debentures + preference share capital/ Equity shareholders fund
- Equity Shareholder’s funds include Reserve and surplus.
- If the ratio is high, the Capital Gearing is said to be high.
- High Gearing is trading on Thin Equity.
- High Gearing is Under Capitalization.
- If the ratio is low, Capital Gearing is said to low.
- Low Gearing is trading on Thick Equity
- Low Gearing is Over Capitalization.
3. Dept-Equity ratio
The financing of total assets of a business concern is done by owner’s Equity as well as outside depts. How much fund has been provided by the owner and how much by outsiders in the acquisition of total assets is a very significant factor affecting long term solvency position of a concern. In Additional, the relationship between borrowed funds and owner capital. It is also known as External Internal equity ratio.
Formula
Debt-Equity Ratio= External equities / Internal Equities
- External Equities
- Total outside Liabilities = Short term debts, Long term debts, debentures.
- Shareholder’s Fund = Pre-Share capital, Equity share capital, Capital reserve, Revenue reserve, Reserve for contingencies, sinking fund for renewal of fixed assets, Redemption of debentures, Less: Fictitious Assets.
- Reminder
- As the acceptable norm for Dept-Equity ratio is considered to be 2:1
4. Ratio of Fixed Assets to Current Assets
An increase in this ratio means that trading is mechanization has been used. A decline in this ratio means that Debtors and stocks are increased too much or fixed assets are more intensively used. If current Assets increase with the corresponding increase in profit, it will show that the business is expanding.
Formula
Fixed Assets to Current Assets = Fixed Assets / Current Assets
5. Ratio of Current Assets to Fixed Asset
Formula
Current Asset to Fixed Asset = Current asset / Fixed asset
6. Reserves to Equity Share Capital Ratio
It reveals the policy pursued by the company with regard to grown shares. Avery’s high ratio indicates a conservative dividend policy and increased plaguing back to profit. The higher the ratio better will be the position.
Formula
Reserve to Equity Capital Ratio = Revenue Reserves / Equity Capital.
7. Solvency Ratio (or) the Ratio of Total Liabilities to Total Assets
It is also known as Debt Ratio. It is a difference of 100 and proprietary ratio or equity ratio. The ratio indicated the relationship between the total liabilities to outsiders to total assets of a firm.
Formula
Solvency Ratio = Total Liabilities to Outsiders / Total Assets
8. Security Ratio
Fixed liabilities usually take the form of debentures, preferably, secured on fixed assets of the company. The market value or depreciated book value of fixed assets should be taken into account at the date of calculation of this ratio. A ratio of 1.5:1 is considered good.