Solvency Ratios and Coverage Ratios

Solvency Ratios

Understanding solvency ratios is crucial for assessing a company's ability to meet its long-term debt obligations. These ratios can broadly be classified into two categories: Debt Ratios and Coverage Ratios.

Debt Ratios

These ratios measure the level of a company's debt compared to its assets and equity. Key ratios include:

• Debt-to-Assets Ratio

  • Formula: \text{Debt-to-Assets Ratio} = \frac{\text{Total Debt}}{\text{Total Assets}}
  • Indicates the proportion of a company's assets that are financed by debt.

• Debt-to-Capital Ratio

  • Formula: \text{Debt-to-Capital Ratio} = \frac{\text{Total Debt}}{\text{Total Debt} + \text{Total Shareholders' Equity}}
  • Shows the relative proportion of debt to equity in the total capital structure.

• Debt-to-Equity Ratio

  • Formula: \text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Shareholders' Equity}}
  • Measures the risk of a company’s capital structure by highlighting the ratio of debt used to finance the business relative to equity.

• Financial Leverage Ratio

  • Formula: \text{Financial Leverage Ratio} = \frac{\text{Total Debt}}{\text{EBIT}}
  • Indicates how much debt is being used to finance the firm’s operations relative to its Earnings Before Interest and Taxes (EBIT).

• Debt-to-EBITDA Ratio

  • Formula: \text{Debt-to-EBITDA} = \frac{\text{Total Debt}}{\text{EBITDA}}
  • Compares debt levels with the earnings generated by the company before interest, taxes, depreciation, and amortization.

Coverage Ratios

These ratios evaluate a company's ability to service its debt and cover interest payments. Important coverage ratios include:

• Interest Coverage Ratio

  • Formula: \text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest Payments}}
  • Measures how easily a company can pay interest on its outstanding debt.

• Fixed Charge Coverage Ratio

  • Formula: \text{Fixed Charge Coverage} = \frac{\text{EBIT} + \text{Lease Payments}}{\text{Interest Payments} + \text{Lease Payments}}
  • Assesses the company’s ability to cover all fixed financial obligations, including interest and lease payments.

Additional Notes

• The term "total debt" refers to the sum of all interest-bearing short-term and long-term debt.
• For reporting purposes in this context, the average total assets divided by average total equity will be referenced, particularly in Dupont analysis. In practice, period-end total assets versus period-end total equity is often used.