Solvent businesses grow and perform better than those that have difficulty meeting their financial obligations. They also attract more investors and find it easier to borrow capital.
Therefore, it’s important to understand how to determine a company’s solvency. There are a few different solvency ratios that can be used to make that assessment.
In this article, we’ll focus on two of them: the debt ratio and the debt-to-equity ratio. With these ratios, you’ll be able to determine whether your company is in good financial health.
The debt ratio
The debt ratio refers to the percentage of a company’s assets that have been financed by creditors, banks, private lenders, etc.
Financial institutions often use this ratio to determine how a company's assets (inventory, vehicles, equipment, land and buildings) are financed.
The lower your debt ratio is, the better banks will consider your ability to pay your debts and take out new loans.
Conversely, a high debt ratio will indicate to them that your company is heavily dependent on debt capital, which may signal that your business is financially unsound.
The concept is similar to calculating a household’s debt-to-income ratio.
Calculating the debt ratio
Companies that offer accounting and tax services can calculate your debt ratio. You can also use online accounting software or make the calculations yourself. Simply divide your debt by your assets (debt/assets). Your business is considered solvent if your debt ratio is equal to or lower than 1.
For example, a company with 50 in assets and 40 in debt would have a debt ratio of 0.8. Conversely, a company with 40 in assets and 50 in debt would have a debt ratio of 1.25. In the first case, the company has a good solvency ratio. In the second, its ratio is risky.
The debt-to-equity ratio
Another way to determine a company’s solvency is the debt-to-equity ratio. This indicator shows a company’s debt compared to the amount of money invested by its owners.
Used by accounting services and banks, among others, this solvency ratio indicates the number of dollars borrowed for each dollar of available equity.
Equity represents all of the company’s financial resources that are considered assets and can be used as collateral once its creditors have been repaid. In other words, the debt-to-equity ratio is a measure of a company’s ability to pay its debts.
Banks generally compare the ratio to industry standards and use it to assess the risk your company presents.
Calculating the debt-to-equity ratio
To calculate your business’s debt-to-equity ratio, you’ll need to divide your debt by your equity (debt/equity). The higher the ratio is, the likelier financial institutions are to consider your company a risk.
If your ratio is greater than 1, your assets are mainly financed by debt. If it is less than 1, your equity provides most of the financing.
Solvency ratio: an indicator of development potential
Calculating your company’s solvency ratio is crucial for determining the state of its financial health. Furthermore, you can use it to track your progress as your business evolves over the years. The solvency ratio is also a useful tool for investors who are considering investing in your company.
So get out your calculator and your financial statements and calculate your company’s solvency ratio today!
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