·         Takes a long-term view.

·         Assess whether Company has over-reached itself through excessive leverage i.e. can it pay principal/interest on loans/debentures etc. on a sustained basis?

Two of the most common solvency ratios are:

 

Interest Coverage Ratio

 This ratio indicates how many times the profit covers fixed interest. It measures the margin of safety for the lenders. The higher the ratio, more secure the lender is in respect to his periodical interest income.

 

Interest Coverage Ratio =	Profit before Interest & Taxes
	Interest Expense

 

Debt-Equity Ratio

The purpose of debt-equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietor and of ‘asset cushion' or cover available to its creditors on liquidation.

 

Debt to Equity =	Total Debt
	Shareholders' Equity

 

Interest has to be paid by the Company out of profits. So long as profits exceed interest payment obligations, the company's creditors can breathe easily. However, shareholders expect higher profits thereafter (dividends), so comparison over past years can show trends e.g.

                                                                                                                                                                                                                                       

Year	Operating Income (Rs.)	Interest (Rs.)	Interest Coverage ratio
2001	28,000	10,000	\28,000/1,000 = 2.8
2002	44,000	12,000	\ 44,000/12,000 = 3.7

                                                                                        
(A better performance than last year).

From Creditors point of view, the higher ratio brings relief.

 

Whether the promoters consider it an improvement or not depends on how they look at profits:

·         A need for high returns/risk i.e. high financial leverage may make them feel that more liabilities could have been raised, to boost turnover further/pay higher dividends or even leverage expansion.

 

It would have increased promoters' rate of return (on investment) at cost of greater risk exposure.