Solvency Ratios

Solvency ratios are financial ratios which measures a company’s ability to pay off its long-term debt and associate interest obligations. Important solvency ratios include debt ratio (i.e. deb to assets ratio), debt to equity ratio, financial leverage ratio (also called equity multiplier) and interest coverage ratio.

While liquidity represents a company’s ability to meet its current liabilities using current assets, solvency refers to a company’s long-term financial strength. It involves comparing total assets with total liabilities to study the company’s overall capital structure and assess its ability to make both principal and interest payments.

The following table lists important solvency ratios and their formulas:

Ratio Formula
Debt ratio (also called debt to assets ratio) Total Debt/Total Assets
Debt to equity ratio Total Debt/Total Equity
Debt to capital ratio Total Debt/(Total Debt + Total Equity
Financial leverage ratio Average Total Assets/Average Total Equity
Times interest earned ratio EBIT/Interest

Debt ratio

Debt ratio is the most popular solvency ratio. It is calculated by dividing total debt by total assets. Total debt equals interest-paying short-term and long-term debt. Total debt doesn’t exactly equal total liabilities. A higher debt ratio means that the company has more debt in its capital structure which it may find difficult to pay back.

Debt to equity ratio

Debt to equity ratio is another ratio that measures the relative portion of debt and equity in a company’s capital structure. A higher debt to equity ratio means a higher debt ratio and higher financial risk. Debt to equity ratio can be converted to debt ratio and vice versa using the following equation:

$$ Debt\ ratio=\frac{D/E\ Ratio}{1+D/E\ Ratio} $$

Debt to capital ratio

Debt to capital ratio measures the proportion of debt with reference to a company’s total capital which equals total debt and shareholders equity.

Debt to capital ratio is similar to debt ratio except for the subtle difference in their denominator. Debt ratio has total assets in its denominator while debt to capital ratio has total capital in its denominator which is not exactly equal to total assets. Total capital is less than total assets which makes debt to capital ratio higher than the debt ratio.

Financial leverage ratio

Financial leverage ratio (also called leverage ratio or equity multiplier) is just another expression of relationship between debt, equity and total assets/capital. Financial leverage ratio measures dollars of total assets per dollar of shareholders equity. It is an important input in in the DuPont analysis of return on equity.

Times interest earned ratio

Times interest earned ratio is a ratio that measures the interest-bearing capacity of a company. It is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense. A higher ratio means that the company profitability is enough to cover the interest expense. It is also called interest coverage ratio.

Example

The following tables calculates debt ratio, debt to equity ratio, debt to capital ratio and financial leverage ratio for Applied Materials Inc (NYSE: AMAT) for the last 5-years:

USD in million Calculation 2013 2014 2015 2016 2017
Total assets A 12,043 13,174 15,308 14,588 19,419
Short-term debt SD 1,200 200
Accounts payable 582 613 658 813 945
Taxes payable 114 193 118 151 182
Accrued liabilities 415 431 432 467 551
Deferred revenues 794 940 765 1,376 1,665
Other current liabilities 538 646 625 625 772
Total current liabilities CL 2,443 2,823 3,798 3,632 4,115
Long-term debt LD 1,946 1,947 3,342 3,143 5,304
Deferred taxes liabilities 71 32 56 1
Pensions and other benefits P 193 208 187 182 160
Other long-term liabilities 302 296 312 413 491
Total non-current liabilities NL 2,512 2,483 3,897 3,739 5,955
Total liabilities L 4,955 5,306 7,695 7,371 10,070
Total stockholders' equity E 7,088 7,868 7,613 7,217 9,349
Debt ratio (SD+LD+P)/A 0.18 0.16 0.31 0.24 0.28
Debt to equity ratio (SD+LD+P)/E 0.30 0.27 0.62 0.49 0.58
Debt to capital ratio (SD+LD+P)/(SD+LD+P+E) 0.23 0.22 0.38 0.33 0.37
Financial leverage ratio A/E 1.69 1.84 2.02 2.05

You can verify that the company’s interest coverage ratio in the last five years has stayed in the range of 4.68-19.84, the highest being in 2016.

The following chart graphs the ratios:

Solvency Ratios

You can see that debt ratio, debt to equity ratio and debt to capital ratio all move together. Further, Debt to capital ratio is more conservative than the debt ratio.

In case of Applied Materials, Inc., the debt ratio and debt to capital ratio has consistently stayed below 0.4 which means that the company has less than $40 of debt per $100 of total capital. This coupled with a very high times interest earned ratio means that the company has very strong solvency position.

Written by Obaidullah Jan, ACA, CFA and last modified on