Did you know that the company does not fully use its capital or equity to support its operational activities? The company also uses debt as a part of its capital. However, the company is not able to take debt immediately. There needs to be a precise calculation to determine how much the company can take on the amount of liability to repay these obligations and avoid bankruptcy. This calculation is solvency ratio.
Definition of Solvency Ratio
Solvency is the company’s ability to repay loans given by creditors, both in the form of short and long term. Short-term solvency is usually measured by comparing it with current assets. Then the solvency ratio is a key metric used to measure an enterprise’s ability to meet its long-term debt obligations and is used often by prospective business lenders.
This ratio provides information on how the company can settle its obligations if one day is liquidated. This ratio is related to funding decisions, in which the company will choose to finance in debt rather than private capital. In other words, the ratio is useful for measuring how much of the company’s assets are consist from debt.
Benefits of Solvency Ratio
The existence of solvency can help companies to avoid the possibility of future difficulties when they want to make payments on loans. The company can find out exactly how much loan the company needs and how much the company’s ability to pay back to creditors.
With solvency, the company will operate in the long term. With the correct solvency ratio calculation, the company will not feeling burden with loans that the company makes, even though in large amounts. Therefore, solvency is the key for a business to avoid these difficulties. The solvency ratio is the company’s benchmark for obtaining loans following financial conditions and measuring how much the company can repay the loan later.
Types and Formulas of Solvency Ratio
Debt to asset ratio
The debt ratio is an index that is useful for evaluating the size of a company based on the amount of debt to raise funds for assets. This ratio serves to compare the amount of wealth and money. This indicator can also show the ability of a company to obtain new loans guaranteed by fixed assets. When the level of this ratio increases, the guarantee from creditors for the long term is increasingly guaranteed. Creditors generally tend to choose companies with low debt ratios. Because the company’s financial position is still safe and not easily bankrupt. The formula for the debt to asset ratio is as follows.
Debt to Asset Ratio = (Total Debt: Total Assets) x 100%
Debt to equity ratio
The debt to equity ratio is usually helpful for comparing equity and liabilities. This means that external capital should not be greater than capital so that the company’s burden does not increase. A small ratio indicates that the company’s condition is improving because the capital to guarantee debt is relatively large. The formula for the debt to equity ratio is as follows.
Debt to Equity Ratio = (Total Debt : Total Equity) x 100%
Tangible asset debt to coverage
This ratio determine the comparison between long-term debt borne by a company with company’s tangible fixed assets. The higher the ratio value to tangible assets, the more the company will have a greater the chance of obtaining a loan. Vice versa, if the value of the tangible asset debt to coverage ratio is low, it indicates that the company’s assets are not sufficient to guarantee the long-term debt. The formula for calculating tangible assets debt to coverage is as follows.
Tangible Assets Debt to Coverage = Tangible fixed assets: Long-term debt
The solvency ratio is a ratio to assess the company’s ability to pay off obligations, both short-term and long-term. With the proper solvency ratio calculation, the company will not feel burden with loans that the company makes. There are three ways to calculate the solvency ratio: the debt to asset ratio, debt to equity ratio, and tangible assets debt to coverage.
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