Overview

Solvency Ratios

A next step in analyzing a company's financial health is to determine how solvent it is. Solvency ratios assess the ability of the company to survive for the long term.
Remembering and understanding this set of ratios is important. They focus on all liabilities, not just current liabilities. This lesson will focus on understanding and
interpreting solvency ratios.

Upon completion of this lesson, candidates should be able to:

Define solvency (2.A.2.d).

Calculate and interpret the following ratios: debt-to-equity, long-term debt-to-equity, and debt-to-total assets (2.A.2.i).

Define, calculate, and interpret the following ratios: fixed charge coverage (earnings to fixed charges), interest coverage (times interest earned), and cash flow to
fixed charges (2.A.2.j).
Study Guide
Solvency Ratios

I. Solvency Ratios
A. Solvency is the ability of a company to survive over a long period of time. In other words, the ability of the company to pay not only its current liabilities
as they come due but also its long-term liabilities.
1. An analysis of solvency uses components from the balance sheet, income statement, and the statement of cash flows.
B. Key Solvency Measures: it is important to understand the terminology that is used when referring to financial statement items. Debt, total debt, liabilities,
and total liabilities are interchangeable terms. Long-term debt, long-term liabilities are interchangeable and can be calculated as total debt minus
current liabilities. Equity, stockholders’ equity, and total stockholders’ equity are interchangeable terms.
1. Debt to Equity measures the relationship between total liabilities and stockholders’ equity:
a. Debt to Equity = Total Debt ÷ Equity
2. Long-term Debt to Equity measures the relationship between only the long-term liabilities and stockholders’ equity:
a. Long-term Debt to Equity = (Total Debt − Current Liabilities) ÷ Equity
3. Debt to Total Assets measures the relationship between total liabilities and total assets. The percentage can be interpreted as how much of the
assets are financed, and therefore owned by, the creditors of the company. The difference between this percent and 100% is the amount of assets
owned by the stockholders.
a. Debt to Total Assets = Total Debt ÷ Total Assets
4. Fixed Charge Coverage (aka Earnings to Fixed Charges Ratio) is a way to measure how well earnings can cover fixed charges. The earnings amount
used is earnings before fixed charges and taxes. Fixed charges include interest, required principal repayment of loans, and leases.
a. Fixed Charge Coverage = Earnings before Fixed Charges and Taxes ÷ Fixed Charges
5. Interest Coverage (aka Times Interest Earned Ratio) is a way to measure how well earnings can cover interest expense.
a. Interest Coverage = EBIT ÷ Interest Expense
6. The cash flow to fixed charges ratio recognizes that payments for fixed charges must be made from cash and not from earnings. It answers the
question, does the company have enough cash to pay for the fixed charges they incur.
a. Cash Flow to Fixed Charges = (Cash from Operations + Fixed Charges + Tax Payments) ÷ Fixed Charges
b. Note that cash from operations is an after-tax amount that is found on the statement of cash flows.
C. Solvency Calculations for Chicago Cereal Company

Kimmel, Paul D. Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, 2015.
1. Debt to Equity = Total Debt ÷ Equity
a. Year 2 = $8,871 ÷ $2,526 = 351.2%
b. Year 1 = $8,645 ÷ $2,069 = 417.8%
2. Long-term Debt to Equity = Long-term Debt ÷ Equity
a. Year 2 = $4,827 ÷ $2,526 = 191.1%
b. Year 1 = $4,625 ÷ $2,069 = 223.5%
Both debt to equity and long-term debt to equity are similar calculations and just slightly different ways of measuring the relationship. For Chicago
Cereal, the relative use of borrowed money to the resources invested by the owners is very high. This is a risky position for the company to be in.
However, both percentages decreased from Year 1 to Year 2, which shows improvement.
3. Debt to Total Assets = Total Debt ÷ Total Assets
a. Year 2 = $8,871 ÷ $11,397 = 78%
b. Year 1 = $8,645 ÷ $10,714 = 81%
In both years, the debt to assets is very high and indicates a large degree of financial leverage. In spite of the slight decrease from Year 1 to Year 2,
Chicago Cereal is highly leveraged and has a high risk that it will not be able to pay its maturing obligations as they come due.
 Kimmel, Paul D. Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, 2015.
4. Fixed Charge Coverage = Earnings before Fixed Charges and Taxes ÷ Fixed Charges. Before this calculation can be done for Chicago Cereal, the
required repayment of principal and the amount of the lease payments are not known and need to be estimated. Let’s assume that repayment of
principal in Year 2 is $200 and Year 1 is $75. Let’s also assume that there are no lease payments being made.
a. Year 2 = ($1,103 + $319 + $200 + $444) ÷ ($319 + $200) = 4.0 times
b. Year 1 = ($1,004 + $307 + $75 + $468) ÷ ($307 + $75) = 4.9 times
The fixed charge coverage rate decreased from Year 1 to Year 2, coming down almost one percentage point. This is not a good indication about
Chicago Cereal’s ability to cover their fixed charges at the current adjusted earnings levels. Reviewing the issuance of debt and the reductions to
debt on the statement of cash flows for both years can give more information. It appears that they refinanced the debt in both years. However, in
both years, the issuance of debt is greater than the reductions to debt.
5. Interest Coverage = EBIT ÷ Interest Expense
a. Year 2 = ($1,103 + $444 + $319) ÷ $319 = 5.8 times
b. Year 1 = ($1,004 + $468 + $307) ÷ $307 = 5.8 times
Chicago Cereal’s EBIT was 5.8 times the amount of interest expense in both years. We don’t know if this is a good indication or not. Comparing it to
General Mills’ 9.9 times shows that Chicago Cereal is not as able to cover interest expense as well as General Mills can. However, when we compare
Chicago Cereal’s 5.8 times to the industry average of 5.5, it shows that it is slightly better.

Kimmel, Paul D. Financial Accounting: Tools for Business Decision Making. Hoboken, NJ: John Wiley & Sons, 2015.
6. Cash Flow to Fixed Charges = (Cash from Operations + Fixed Charges + Tax Payments) ÷ Fixed Charges
a. Year 2 = ($1,503 + 519 + $444) ÷ $519 = 4.8 times
b. Year 1 = ($1,410 + 382 + $468) ÷ $382 = 5.9 times
The cash flow to fixed charges is giving a better indication of Chicago Cereal’s ability to pay the cash needed for the fixed charges than the fixed
charge coverage did. Similar to the fixed charge coverage results, these calculations show that the result has come down just over one percentage
point from Year 1 to Year 2. Remember that these fixed charges must be paid with cash.
Overall Chicago Cereal’s solvency is acceptable, although not very good. Most of the calculations improved from Year 1 to Year 2, which indicates
that its solvency has improved.

Summary
Solvency ratios assess the ability of an entity to survive for the long term. This means that it will stay in business long enough to repay all liabilities, not only short-
term, but long-term, too. It is important to remember the formulas to perform the calculations, be able to interpret the results, and provide an assessment of an
entity’s solvency.
Flashcards
Solvency Ratios

1
FC.solvency.rat.FC001_1709

What is solvency? Solvency is the ability of a company to survive over a long period of
time. In other words, the ability of the company to pay not only its
current liabilities as they come due but also its long-term liabilities.

2
FC.solvency.rat.FC002_1709

What is the formula for Debt to Equity? Debt to Equity = Total Debt ÷ Equity

3
FC.solvency.rat.FC003_1709

What is the formula for Long-term Debt to Equity? Long-term Debt to Equity = Long-term Debt ÷ Equity

4
FC.solvency.rat.FC004_1709

What is the Debt to Total Assets Ratio?

Debt to Total Assets = Total Debt ÷ Total Assets

This ratio can be interpreted as how much of the assets are financed,
and therefore owned by, the creditors of the company. The difference
between this percent and 100% is the amount of assets owned by the
stockholders.

5
FC.solvency.rat.FC005_1709

What is the Fixed Charge Coverage Ratio?

Fixed Charge Coverage = Earnings before Fixed Charges and Taxes ÷
Fixed Charges

This is a way to measure how well earnings can cover fixed charges.

6
FC.solvency.rat.FC006_1709

What is the Interest Coverage (Times Interest Earned) Ratio?

Interest Coverage = EBIT ÷ Interest Expense

This shows how well earnings can cover interest expense.

7
FC.solvency.rat.FC007_1709
What is the Cash Flow to Fixed Charges Ratio?
Cash Flow to Fixed Charges = (Cash from Operations + Fixed Charges
+Tax Payments) ÷ Fixed Charges

This shows how well adjusted cash from operations can cover fixed
charges.
Notes
Solvency Ratios

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