Debt and Solvency Ratios
Introduction
Solvency is the ability of a company to meet its long-term financial obligations. This ratio group is concerned with identifying absolute and relative levels of debt, financial leverage, and capital structure.
These ratios allow users to gauge the degree of inherent financial risk, as well as the potential of insolvency. Financial risk is a relative measure; the absolute amount of debt used to finance assets and operations is by itself not that meaningful. In other words, there is no right or wrong amount of debt. The company may be evaluating in context of ability to carry or service liabilities.
Debt Ratio
The debt ratio is the most basic indicator of solvency which identifies the percentage of assets that are funded by liabilities. There is no set rule for the result but one could expect to see a rough range of results between 60%-80% across a broad spectrum of most industries. Financial institutions conversely are highly leveraged and ratios with results of 90%+ are common. Ratios below 50% are infrequent, with the possible exception of small family owned businesses.
This ratio by itself is not especially important. It tells the level of debt or leverage, but the result needs to be considered in relation to the enterprise as a whole. High leverage can be positive if the company is able to support and take advantage of it. This ratio is therefore a starting point to solvency analysis. Analysts will quickly move on from this point by focusing attention to the composition of liabilities, earnings, cash flow, and coverage.
- Measures the relationship between total liabilities and total assets
- Basic indicator of risk, leverage, and solvency
- Favorable: lower result
- Lower results indicate a higher percentage of equity employed to fund or support operations
Debt to Equity Ratio
The debt to equity ratio provides a different perspective on the manner in which a company funds its assets. It is a measure of leverage and a preliminary indicator of solvency. As with the debt ratio, there is no standard generic benchmark from which to judge all companies. This metric should be considered in large part by the industry type being analyzed while performing quality peer group analysis.
Trend analysis (comparing company results over a number of years) is also helpful in understanding debt to equity ratio. Should the ratio results rise over time, for example, this trend would likely suggest increased use of bank financing or worse, signal operational issues. Such a trend would require further attention and investigation.
- Measures the relationship of total liabilities to shareholders’ equity
- Indicator of financial leverage
- Favorable: lower result
- Lower results indicate less risk in operations
Equity Ratio
In almost all cases, a strong equity to assets ratio is a positive sign, especially from a risk or solvency perspective. A high equity ratio is generally a common trait of quality, well performing companies. The equity ratio by itself, however, does not explain how the level of equity was achieved. A high degree of equity can be present for a variety of reasons, from seed funded startups to long-running, historically successful companies with significant retained earnings. Another possible event that could distort the usefulness of this measure could be a large secondary