4.4. Solvency ratios

Equity ratio

One of the most common solvency ratios is the equity ratio:

  • \(Equity\ ratio=\frac{Equity}{Total\ asset}\)

Equity ratio is limited between 0 and 1 (although in exceptional situations, if the company’s equity is negative, equity ratio will be too) and determines the proportion between equity and the total assets, thus being benchmark of leverage. For this reason, it is one of the main indicators of the company’s risk, in particular when the company is searching for new debt: funders will want to identify the level of the equity ratio before and after funding. The higher is the ratio the greater confidence that the funders will have to grant credit to the company, because in the event of a dissolution of the company, there is a greater likelihood that the company’s assets can cover the liabilities of the company, including those regarding credits granted. Additionally, a high equity ratio demonstrates that equity holders are more committed to the company. Hence the manager will have a tendency to hold on the risk that they are willing to take.

Equity-to-liabilities ratio

The Equity-to-liabilities ratio demonstrates the company’s ability to comply with its financial obligations, by demonstrating the relation between equity and total liabilities.

  • \(Equity-to-liabilities\ ratio=\frac{Equity}{Total\ liabilities}\)

When the solvency is equal to 1, it means that there is an equality between equity and liabilities, meaning the company has enough own resources to cover liabilities claims. If the value is inferior to 1, then it means that the company has more liabilities than equity, thus the coverage of the liabilities in the future is also dependent on its ability to generate income.

Liabilities-to-assets ratio

As it is obvious by the understood by its nomenclature, this ratio provides the relationship between liabilities and assets. The liabilities-to-assets ratio is given by the ratio between total liabilities and total assets.

  • \(Liabilities-to-assets\ ratio=\frac{Total\ liabilities}{Total\ assets}\)

It can also be calculated from the equity ratio.

  • \(Liabilities-to-assets\ ratio=1-equity\ ratio\)

This ratio is often called debt ratio or debt-to-assets ratio, but such definition conveys an ambiguity between the terms “debt” and “liabilities”, which as you have seen, are not the same.

Coverage of the fixed asset

The coverage fixed asset ratio analyses if the investment assets are covered through by permanent financing. The ideal situation is to be on a situation where the ratio is at least 1, as this means that the company is financing long-term assets based on long-term resources. However, it will be necessary to take into consideration any specificity of the company.

  • \(Coverage\ of\ the\ fixed\ asset=\frac{Permanent\ capital}{Fixed\ asset}\)