Assessing Risk with Solvency Ratios
The final group of ratios are designed to help you measure the degree of financial risk that your business faces. "Financial risk," in this context, means the extent to which you have debt obligations that must be met, regardless of your cash flow. By looking at these ratios, you can assess your level of debt and decide whether this level is appropriate for your company.
Commonly used solvency ratios encompass:
- Debt to Equity
- Debt to Assets
- Coverage of Fixed Costs
- Interest Coverage
Understanding your debt to equity
The debt-to-equity ratio can be computed with the following formula, using figures from your balance sheet:
Owners' (or Stockholder's) Equity
The ratio of debt-to-owner's equity or net worth indicates the degree of financial leverage you're using to enhance your return. A rising debt-to-equity ratio may signal that further increases in debt caused by purchases of inventory or fixed assets should be restrained.
Improving this ratio involves either paying off debt or increasing the amount of earnings retained in the business until after the balance sheet date. For instance, can expenses be deferred beyond the balance sheet date to increase your retained earnings? What about bonuses?
Delaying any planned bonus expense serves to increase your retained earnings. As another example, you might think about repaying revolving debt (such as a line of credit) before the balance sheet date and borrowing again after the balance sheet date.
Understanding your debt to assets
This ratio measures the percentage of a business's assets that are financed with debt, and can be calculated using the following formula:
This ratio measures the percentage of assets financed by creditors, compared to the percentage that have been financed by the business owners. Historically, a debt-to-asset ratio of no more than 50 percent has been considered prudent. A higher ratio indicates a possible overuse of leverage, and it may indicate potential problems meeting the debt payments.
Improving this ratio means taking steps to either increase the value of your assets, or to pay off debt. For example, you might explore whether inventory or other assets can be given a higher value. If you go the route of paying off debt, you'll also improve your current ratio and debt-to-equity ratio.
Understanding your coverage of fixed charges
Coverage of fixed charges is also sometimes called "times fixed charges earned."
It can be computed by:
- taking your net income before taxes and fixed charges (debt repayment, long-term leases, preferred stock dividends etc.)
- dividing by the amount of fixed charges
The resulting number shows your ability to meet your fixed obligations of all types — the higher the number, the better.
Obviously, an inability to meet any fixed obligation of the business threatens your business's well-being. Many working capital loan agreements will specify that you must maintain this ratio at a specified level, so that the lender has some assurance that you'll continue to be able to make your payments.
Understanding your interest coverage
Also known as the "times interest earned ratio," interest coverage is very similar to the "times fixed charges earned" ratio but focuses more narrowly on the interest portion of your debt payments.
To calculate this ratio, you can use the following formula:
By comparing the ratio of operating income to interest expense, you measure how many times your interest obligations are covered by earnings from operations. The higher the ratio, the bigger your cushion and the more able the business is to meet interest payments. If this ratio is declining over time, it's a clear indication that your financial risk is increasing.