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How would you study the solvency position of the firm?

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The solvency position of any firm is determined and measured with the help of solvency ratios. In this way we can say that the ratios which throw light on the debt servicing ability of the businesses in the long run are known as solvency ratios. Solvency of a concern can be measured in two ways first to check the security of Debt and second is to check the security of return on Debt. For calculating the security of debt we calculate Debt-Equity Ratio, Proprietory Ratio, Fixed Assets – Proprietory Fund Ratio, etc. And for calculating Security of Return on Debt we calculate Interest Coverage Ratio. 

A brief description of the above mentioned ratios is as follows Debt Equity 

Ratio :Debt Equity Ratio: indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds. It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.

Proprietory Ratio/ Total Assets to Debt Ratio: Total assets to Debt Ratio or Proprietory Ratio are a variant of the debt equity ratio. It is also known as equity ratio or net worth to total assets ratio. This ratio relates the shareholder’s funds to total assets. Proprietory/Equity Ratio indicates the long-term or future solvency position of the business. Formula of Proprietary/Equity Ratio

Shareholder’s funds include equity share capital plus all reserves and surpluses items. Total assets include all assets, including Goodwill. Some authors exclude goodwill from total assets. In that case the total shareholder’s funds are to be divided by total tangible assets. The total liabilities may also be used as the denominator in the above formula. 

Fixed Assets to Proprietor’s Fund Ratio: Fixed Assets to Proprietor’s Fund Ratio establish a relationship between fixed assets and shareholders’ funds. The purpose of this ratio is to indicate the percentage of the owner’s funds invested in fixed assets. The formula for calculating this ratio is as follows

The fixed assets are considered at their book value and the proprietor’s funds consist of the same items as internal equities in the case of debt equity ratio.

Interest Coverage Ratio :This ratio deals only with servicing of return on loan as interest. This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

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