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Solvency Ratios

Solvency (Leverage and Debt Service)

Solvency is the company's ability to satisfy long-term debt as it becomes due. One should be concerned about the long-term financial and operating structure of any firm in which one might be interested. Another important consideration is the size of the debt in the firm's capital structured referred to a financial leverage. (Capital structure is the mix of the long-term sources of funds used by the firm).

Solvency also depends on earning power; in the long run, a company will not satisfy its debts unless it earns profit. A leveraged capital structure subjects the company to fixed interest charges, which contributes to earnings instability. Excessive debt may also make it difficult for the firm to borrow funds at reasonable rates during tight money markets.

The debt ratio reveals the amount of money a company owes to its creditors. Excessive debt means greater risk to the investor. The debt ratio is:

Debt ratio = Total liabilities

Total assets

The debt-equity ratio will show if the firm has a great amount of debt in its capital structure. Large debts mean that the borrower has to pay significant periodic interest and principal. Also, a heavily indebted firm takes a greater risk of running out of cash in difficult times. The interpretation of this ratio depends on several variables, including the ratios of other firms in the industry, the degree of access to additional debt financing, and stability of operations.

Debt-equity ratio = Total liabilities

Stockholder's equity

Times interest earned (interest coverage ratio) tells how many times the firm's before-tax earnings would cover interest. It is a safety margin indicator in that it reflects how much of a reduction in earnings a company can tolerate.

Times interest earned = Income before interest and taxes

Interest expense

One must also note liabilities that have not yet been reported in the balance sheet by closely examining footnote disclosure. For example, one should find out about lawsuits, noncapitalized leases, and future guarantees.

 

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