# 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.

#### Example case: Dutch Fabric Innovations

Let’s consider the following items representative of DFI’s activity:

 Values in EUR 2020 2021 2022 2023 2024 Equity 127 278,66 264 403,21 874 088,57 2 381 535,00 5 100 529,04 Total Assets 320 789,44 1 182 507,44 2 666 762,25 5 229 773,33 9 427 731,42 Equity Ratio 39.67 % 22.36 % 32.77 % 45.53 % 54.10 %

As it is possible to observe in the table, the lowest value of the Equity Ratio obtained by Dutch Fabric Innovations was 22,36%, in 2021. In this year, equity has a value of 264 403,21€ and total assets have a value of 1 182 507,44€.

• $$Equity\ Ratio=\frac{264\ 403,21}{1\ 182\ 507,44}=22,36$$%

Most assets were financed with debt and only 23,35% of the assets are owned by investors.

#### Example case: Golden Days

Let’s consider the following elements from Golden Days’ balance sheet:

 Values in USD 2019 2020 2021 2022 2023 Equity 163 031,76 384 414,62 650 950,85 868 272,23 1 117 582,52 Total Assets 187 744,09 443 550,43 837 955,75 1 093 579,01 1 386 329,18 Equity Ratio 86,83% 86,66% 77,68% 79,39% 80,61%

The lowest value of the Equity Ratio obtained by Golden Days was 77,68%, in 2021:

• $$Equity\ Ratio=\frac{650\ 950,85}{837\ 955,75}=77,68$$%

Such a result tells us that, although the value is lower than 100%, it is quite high, allowing the shareholders to have some confidence to invest in the company.

Moreover, a ratio of 77,68% means that a big part of the assets was financed by investors and not with debt. Only 22,32% of the assets are owned by creditors and not by investors.

This Equity Ratio is favorable because it shows to future investors that the current ones are committed with Golden Days and believe that the company is a good investment.

However, the value from 2021 makes part of a decrease, since the project started in 2019 with an Equity Ratio of 86,83%. This decrease happens because from 2020 on, the total assets grow much faster than equity.

## 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.

#### Example case: Dutch Fabric Innovations

Let’s consider the following items from DFI’s balance sheet:

 Values in EUR 2020 2021 2022 2023 2024 Equity 127 278,66 264 403,21 874 088,57 2 381 535,00 5 100 529,04 Total Liabilities 193 510,78 918 104,23 1 792 673,67 2 848 238,33 4 327 202,37 Equity-to-liabilities ratio 65,77% 28,79% 48,75% 83,61% 117,87%

In 2021, with an equity of 264 403,21€ and total liabilities of 918 104,23€, DFI has an Equity-to-Liabilities Ratio of

• $$Equity-to-liabilities\ ratio=\frac{264\ 403,21}{918\ 104,23}=28,79$$%

This shows a lower ability to comply with its obligations, when compared to the same ratio in the other years.

If we focus on the percentage obtained for 2024, we can conclude that the company has more equity than total liabilities.

#### Example case: Golden Days

Let’s consider the following elements resultant from Golden Days activity:

 Values in USD 2019 2020 2021 2022 2023 Equity 163 031,76 384 414,62 650 950,85 868 272,23 1 117 582,52 Total Liabilities 24 712,32 59 135,81 187 004,89 225 306,77 268 746,66 Equity-to-liabilities ratio 659,71% 650,05% 348,09% 385,37% 415,85%

In 2019, Golden Days has an Equity-to-Liabilities Ratio of

• $$Equity-to-Liabilities\ Ratio=\frac{163\ 031,76}{24\ 712,32}=659,71$$%

This shows a very strong ability to comply with its obligations. In fact, in all five years, the ratio always presents values above 100%, given the big amount of equity compared to the small liabilities.

The percentages decrease a lot through time, but being above 100%, we can conclude that the company has always more equity than total liabilities and therefore does not depend on the amount of income generated to be able to pay its liabilities.

## 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.

#### Example case: Dutch Fabric Innovations

Consider once again DFI’s total assets and total liabilities:

 Values in EUR 2020 2021 2022 2023 2024 Total Liabilities 193 510,78 918 104,23 1 792 673,67 2 848 238,33 4 327 202,37 Total Assets 320 789,44 1 182 507,44 2 666 762,25 5 229 773,33 9 427 731,42 Liabilities-to-assets ratio 60,32% 77,64% 67,22% 54,46% 45,89%

Using once again DFI’s total liabilities and total assets for the year of 2021, we obtain

• $$Liabilities-to-assets\ ratio=\frac{918\ 104,23}{1\ 182\ 507,44}=77,64$$%

#### Example case: Golden Days

Consider once again DFI’s total assets and total liabilities:

 Values in USD 2019 2020 2021 2022 2023 Total Liabilities 24 712,32 59 135,81 187 004,89 225 306,77 268 746,66 Total Assets 187 744,09 443 550,43 837 955,75 1 093 579,01 1 386 329,18 Liabilities-to-assets ratio 13,16% 13,33% 22,31% 20,60% 19,38%

Using Golden Days’ total liabilities and total assets for the year of 2021, we obtain a Liabilities-to-Assets Ratio of 22,31%:

• $$Liabilities-to-Assets\ Ratio=\frac{187\ 004,89}{837\ 955,75}=22,31$$%

This ratio is complementary of the equity ratio and together they must sum 1. Given this, they have opposite interpretations and such a low Liabilities-to-Assets ratio is actually very positive.

In fact, it represents a low financial risk and, once again, investment in assets was made much more through equity than through debt. What’s more, there is a lot of confidence in the company from investors because the company presents a high ability to repay investors’ funds.

## 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.

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

#### Example case: Dutch Fabric Innovations

Let’s consider the following elements from DFI’s income statement and balance sheet:

 Year 2020 2021 2022 2023 2024 Permanent Capital 127 278,66 381 403,21 979 088,57 2 474 535,00 5 181 529,04 Fixed Assets 172 658,15 156 167,75 345 431,05 360 542,35 306 752,95 Coverage of the fixed asset ratio 73,72% 244,23% 283,44% 686,34% 1689,15%

In 2020, DFI expects to have a permanent capital of 127 278,66€ (composed only of equity since the company does not hold any bank loan in this year) and fixed assets of 172 658,15€.

• $$Coverage\ of\ the\ fixed\ asset=\frac{127\ 278,66}{172\ 658,15}=73,72$$%

A coverage of fixed asset of 73.72% means that the company is not entirely able to finance its long-term assets with its permanent financing resources, and therefore part of its long-term assets are being financed with short-term resources. In 2021, the situation is reverted: the ratio increases and the company is no longer dependent on the short-term financing.

#### Example case: Golden Days

Let’s consider the following elements from Golden Days’ income statement and balance sheet:

 Values in USD 2019 2020 2021 2022 2023 Permanent Capital 163 031,76 384 414,62 650 950,85 868 272,23 1 117 582,52 Fixed Assets 5 141,70 24 320,19 17 200,14 26 644,57 18 405,77 Coverage of the fixed asset ratio 3170,78% 1580,64% 3784,57% 3258,72% 6071,91%

Permanent capital is given by the sum of total equity with bank loans. Golden Days does not incur into any bank loan during the first five years of the project, and consequently, permanent capital is exactly equal to equity. In 2019, Golden Days expects to have a permanent capital of 163 031,76$and fixed assets of 5 141,70$. This leads to

• $$Coverage\ of\ the\ fixed\ asset=\frac{163\ 031,76}{5\ 141,70}=3\ 170,78$$%

This means that the company is perfectly capable of financing its long-term assets with its permanent financing resources.

Through time, the ratio varies a lot, but it’s always above 100%.