Question

Long Answer Question

How would you study the solvency position of the firm?

Answer 1

Solvency position of a firm is studied with the help of the Solvency Ratios. Solvency ratios are the measures of the long-term financial position of the firm in terms of its ability to pay its long-term liabilities. In other words, the solvency of the firm is measured by its ability to pay its long term obligation on the due date. The long term obligations include payments of principal amount on the due date and payments of interests on the regular basis. Long term solvency of any business can be calculated on the basis of the following ratios.

a. Debt-Equity Ratio- It depicts the relationship between the borrowed fund and owner’s funds. The lower the debt-equity ratio higher will be the degree of security to the lenders. A low debt-equity ratio implies that the company can easily meet its long term obligations.

`"Debt-Equity ratio" = "Long-term Debt"/"(Equity / share Holders Fund)"`

Equity or the Shareholders Fund includes Preference Share Capital, Equity Share Capital, Capital Reserve, Securities Premium, General Reserve less Accumulated Loss and Fictitious Assets

b. Total Assets to Debt Ratio- It shows the relationship between the total assets and the long term loans. A high Total Assets to Debt Ratio implies that more assets are financed by the owner’s fund and the company can easily meet its long-term obligations. Thus, a higher ratio implies more security to the lenders.

`" Total Assets to Debt Ratio"= "Total Assets"/ "Long-Term Debt"`

Total Assets includes all fixed and current assets except fictitious assets like, Preliminary Expenses, Underwriting Commission, etc.

Debt includes all long-term loans that are to be repaid after one year. It includes debentures, mortgage loans, bank loans, loans from other financial institutions, etc.

c. Interest Coverage Ratio- This ratio depicts the relationship between amount of profit utilise for paying interest and amount of interest payable. A high Interest Coverage Ratio implies that the company can easily meet all its interest obligations out of its profit.

`"Interest Coverage Ratio" = "Net Profit Before Interest And Tax"/"Interest On Long Term Loans"`

d. Proprietary Ratio- It shows the relationship between the Shareholders Fund and the Total Assets. This ratio reveals the financial position of a business. The higher the ratio the higher will be the degree of safety for the creditors. It is calculated as:

`"Proprietary Ratio" = " Shareholders Fund"/" Total Asssets"or"Equity"/"Total Assets"`

Total Assets includes all fixed and current assets except fictitious assets like, Preliminary Expenses, Underwriting Commission, etc.