Principles of Finance

# 6.4Solvency Ratios

Principles of Finance6.4 Solvency Ratios

By the end of this section, you will be able to:

• Evaluate organizational solvency using the debt-to-assets and debt-to-equity ratios.
• Calculate the times interest earned ratio to assess a firm’s ability to cover interest expense on debt as it comes due.

Solvency implies that a company can meet its long-term obligations and will likely stay in business in the future. Meeting long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency ratios are the debt-to-equity ratio and the times interest earned ratio.

## Debt-to-Assets Ratio

The debt-to-assets ratio shows the relationship between debt and assets. It reflects how much of the assets of the business was financed through debt. It reflects the company’s leverage and is helpful to analysts in comparing how leveraged one company is compared to another.

Debts normally carry interest expense and must be repaid. The debt-to-assets ratio includes all debt—both long-term debt and current liabilities. The formula for the debt-to-assets ratio is

6.21

The information needed to compute the debt-to-assets ratio for Clear Lake Sporting Goods in the current year can be found on the balance sheet. The debt-to-assets ratio for Clear Lake Sporting Goods in the current year is

6.22

This means that 60 percent of Clear Lake’s assets are financed by debt. We can also then infer that the other 40 percent is financed by equity. A ratio higher than 1.0 means the company has more debts than assets, which means it has negative equity. In Clear Lake’s case, a 60 percent debt-to-assets ratio indicates some risk, but perhaps not a high risk. Comparing Clear Lake’s ratio to industry averages would provide better insight.

## Debt-to-Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations running. A key difference in debt and equity is the interest expense repayment that a loan carries as opposed to equity, which does not have this requirement. Therefore, a company wants to know how much debt and equity contribute to its financing. The formula for the debt-to-equity ratio is

$Debt-to-Equity Ratio=Total LiabilitiesTotal Stockholder EquityDebt-to-Equity Ratio=Total LiabilitiesTotal Stockholder Equity$
6.23

The information needed to compute the debt-to-equity ratio for Clear Lake Sporting Goods in the current year can be found on the balance sheet.

6.24

## Times Interest Earned (TIE) Ratio

The times interest earned (TIE) ratio measures the company’s ability to pay interest expense on all debt incurred. This ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit. The more times over a company can cover interest, the more likely a lender will extend long-term credit. The formula for times interest earned is

6.25

The information needed to compute times interest earned for Clear Lake Sporting Goods in the current year can be found on the income statement.

6.26

The \$43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome suggests that Clear Lake Sporting Goods can easily repay interest on an outstanding loan and creditors would have little risk that Clear Lake Sporting Goods would be unable to pay.