We are currently entering a period of economic downturn, in this climate it is more important than ever to check the solvency of other businesses before dealing with them.
There are a number of solvency ratios but they all have a common purpose – to measure business risk, specifically the risk attached to your ability to pay your debts in the absence of any cash flow. Investors are very interested in these ratios because they indicate the amount of debt your company can handle. By indicating the amount of investment equity you have in your company they tell whether it owns more than it owes.
Debt To Equity Ratio: the debt to equity ratio measures your net worth. If your debt to equity ratio is growing quickly it’s an indication that you need to decrease your liabilities before taking on more debt.
Formula: total debt / owner’s or stockholder’s equity
Paying off debt or increasing the amount of earnings retained in the business (at least until after the balance sheet date) will improve the ratio. You might opt to defer paying some of your debts, cut back on inventory purchases or delay a major fixed asset purchase.
Debt To Assets Ratio: shows you the percentage of your assets that are being financed by your creditors, that is, financed through debt as opposed to by the business.
Formula: total debt / total assets
Generally it’s considered sensible to finance less than 50% of your assets by debt. A higher ratio could mean a problem meeting repayments if cash flow slows. You can reduce this ratio by paying off debt or by increasing the value of your assets – could you have more value tied up in inventory than you estimated for instance?
Coverage Of Fixed Costs Ratio: shows how easily you can pay your fixed costs. Coverage of fixed costs is also sometimes called ‘times fixed charges earned’.
Formula: (net income before taxes + fixed costs) / fixed costs
Fixed costs are costs that remain pretty much the same even when sales increase or decrease (such as rent on premises). If you cannot cover your fixed costs as they come due your business is in serious jeopardy so the higher the number the better. Many working capital loan agreements specify that you must maintain this ratio at a certain level as an assurance that you continue to have the wherewithal to make repayments.
Interest Coverage Ratio: represents how many times the net income generated by your business, without considering interest and taxes, covers the total interest charge on it. It is also referred to as ‘number of times interest earned’.
Formula: net income before interest and taxes / interest expense
It is similar to the Coverage Of Fixed Costs ratio but narrower in focus – it relates to just the interest portion of your debt liability. It shows by how many times your interest obligations are covered by your earnings from operations. The higher the ratio, the better your ability to meet interest payments.
Debt and equity are two key elements of your financial statement and lenders or investors often use the relationship between them to evaluate their risk in providing funds. In general, the lower a company’s reliance on debt to finance its assets, the less risky the company. By checking these ratios you can assess your level of debt overall and in relation to a number of specific obligations and decide whether it is at an appropriate level or if you are at risk and need to address the situation.