Assessing Risk with Solvency Ratios
The final group of ratios
- Debt to Equity
- Debt to Assets
- Coverage of Fixed Costs
- Interest Coverage
Understanding Your Debt to Equity
The debt-to-equity ratio can be computed with the following formula, using figures from your balance sheet:
The ratio of
Improving this ratio involves either paying off debt or increasing the
Delaying any planned bonus expense serves to increase your retained earnings. As another example, you might think about repaying revolving debt (such as a line of credit) before the balance sheet date and borrowing again after the balance sheet date.
Understanding Your Debt to Assets
This ratio measures the percentage of a business's assets that are financed with debt, and can be calculated using the following formula:
This ratio measures the percentage of assets financed by creditors, compared to the percentage that
Improving this ratio means taking steps to either increase the value of your
Understanding Your Coverage of Fixed Charges
Coverage of fixed charges is also sometimes called "times fixed charges earned."
It can be computed by:
- taking your net income before taxes and fixed charges (debt repayment, long-term leases, preferred stock dividends etc.)
- dividing by the
amountof fixed charges
The resulting number shows your ability to meet your fixed obligations of all types — the higher the number, the better.
Obviously, an inability to meet any fixed obligation of the business threatens your business's well-being. Many working capital loan agreements will specify that you must maintain this ratio at a specified
Understanding Your Interest Coverage
Also known as the "times interest earned ratio," interest coverage is very similar to the "times fixed charges earned" ratio but focuses more narrowly on the interest portion of your debt payments.
To calculate this ratio, you can use the following formula:
By comparing the ratio of operating income to interest expense, you measure how many times your interest obligations are covered by earnings from operations. The higher the ratio, the bigger your cushion and the