Analyzing Financial Statements using Solvency Ratios

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  • 0:03 What Is Solvency?
  • 1:16 Debt Ratio
  • 2:03 Equity Ratio
  • 2:50 Debt-to-Equity Ratio
  • 3:22 Lesson Summary
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Lesson Transcript
Instructor: Tammy Galloway

Tammy teaches business courses at the post-secondary and secondary level and has a master's of business administration in finance.

In this lesson, we'll define solvency and learn about three solvency ratios: debt, equity, and debt to equity.We'll also learn how to analyze each ratio and determine if a high or low ratio is positive or negative.

What Is Solvency?

Jeanna owns a widget business and won the Entrepreneur of the Year award from a top accounting firm. After reading about the award in a magazine, a large manufacturing company contacted her to purchase $500,000 of her widgets. Jeanna was excited, but knew she needed a loan for materials and labor to meet the demand of such a large order. However, when she completed a loan application, it was denied. She's meeting with the loan officer, Ron, to gain a better understanding of the financial improvements she can make to have her loan approved. Ron explains that solvency was the main reason the application was denied. Solvency is the ability to pay obligations long term.

Jeanna is a little perplexed because the company's liquidity ratios were positive according to the accounting firm that gave the award. Ron explains that many are confused by the difference between liquidity and solvency. Liquidity is a company's ability to pay short term obligations, whereas solvency is more long term in nature. Ron shows Jeanna the three main ratios the bank reviewed to make their decision: debt, equity, and debt-to-equity. Let's take a closer look of his explanation.

Debt Ratio

When companies make a substantial purchase or investment in assets, one of their financing options is debt. Debt comes in the form of obtaining loans or issuing bonds. Bonds are similar to an I.O.U.; investors loan the company money by purchasing bonds and expect interest payments and the repayment of the loan at maturity.

The debt ratio measures how much of the company's assets are financed through debt (loans and bonds). The debt ratio is calculated by total liabilities divided by total assets. The higher the percentage, the more leveraged, or in debt, the company is. There are different leverage measurements based on the industry; however, the bank prefers a debt ratio of 40% or less. Jeanna's widget company debt ratio was 70%.

Equity Ratio

The widget company also sold stock, which is the other financing option. Stock represents a share of a corporation. Investors purchase shares in return for voting rights, appreciation, and dividends. While the widget company does not have a responsibility to return the shareholder's investment, they are required to issue dividends to specific shareholders.

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