Financial Ratios: Solvency: Lesson 2.5

Unit 2: Financial Statement: A Review
Lesson 2.5
Financial Ratios: Solvency
Contents
Introduction 1
Learning Objectives 2
Quick Look 3
Learn the Basics 4

Solvency Ratio 5
Uses of Solvency Ratio 5
Limitation of Solvency Ratio 6
Types of Solvency Ratios 7
Equity-to-Assets Ratio 7
Debt-to-Assets Ratio 8
Debt-to-Equity Ratio 9
Analysis and Interpretation of Solvency Ratios 11
Solvency Ratio 11
Equity-to-Asset Ratio 12
Debt-to-Asset Ratio 13
Debt-to-Equity Ratio 13
Keep in Mind 15
Try This 15
Practice your Skills 17
Challenge Yourself 20
Photo Credit 21
Bibliography 21
Appendix 22
Statement of Comprehensive Income and Financial Position 22
Lesson 2.5
Financial Ratios: Solvency
Introduction
Do you know how much money entrepreneurs need to establish their businesses? They
would need to raise substantial capital to finance startup costs such as equipment,
properties, product development, legal fees, etc. Most startups take on debts to raise funds
and get their business off the ground.
Mature and established businesses also acquire capital from debt financing. They may need
to upgrade or maintain their assets, such as their properties, plants, buildings, technologies,
2.5 Financial Ratios: Solvency 1

and equipment. They may also require additional capital to expand their operations and
enter new markets.
Businesses may incur long-term debts to finance their investments and important
milestones. These financial obligations are usually larger than ordinary liabilities and have
maturities longer than a year. These debts incur bigger interests as well. Hence, a company
needs to measure the ability of the firm to attend to its long-term liabilities. A practical
financial tool for this is the solvency ratio.
Learning Objectives DepEd Competencies
● Define the measurement levels; namely,

At the end of this lesson, you should be able to
liquidity, solvency, stability, and
do the following:
profitability (ABM_BF12-IIIb-7).
● Define solvency ratios. ● Compute, analyze, and interpret financial
● Discuss the different solvency ratios. ratios (ABM_BF12-IIIb-9).
● Compute for various solvency ratios.
● Interpret solvency ratios.

Quick Look
Essential Long-term Debts
A famous saying holds that the best things in life are free. However, reality shows that the
essential things necessary to live a comfortable life, such as tuition fees for education to
qualify for a job, a house, a lot for the family home, or a private car for convenient daily
transportation, require tremendous financial support investments.
Year after year, they only become more expensive. Some people, especially the younger
generations, do not have enough money for these enormous purchases. It may take years
before they can have the cash to afford them. That is why financial institutions offer loans to
help individuals buy these things. These loans are usually paid at various interest rates, with
different payment schedules.
As most of these debts are substantial and take years to be paid fully, one must discern
carefully before obtaining a long-term loan. Paying for a huge purchase for years can
significantly affect a person's financial well-being for a long time. It is highly suggested to
evaluate the necessity of the purchase and examine the loan terms before taking it.
Questions to Ponder
1. Why do some people incur long-term debts?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
2. Do you think long-term debts are bad? Why or why not?
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________

3. Why do you think it is important to think thoroughly before getting a long-term debt?
Cite examples to illustrate your point.
________________________________________________________________________________________
________________________________________________________________________________________
________________________________________________________________________________________
Learn the Basics
Like individuals, companies also need to acquire investments to grow and achieve their goals.
Businesses may need to engage in various ventures and buy numerous assets to enhance
their products or proceed with their expansion initiatives. These activities typically require
huge amounts of money. Businesses may obtain big loans, which are paid over long periods
to finance these development pursuits.
In the previous lessons, you have learned that financial ratios are essential instruments in
assessing a company’s financial health and performance. For instance, liquidity ratios reflect
the company’s ability to settle its short-term obligations, while profitability ratios describe its
earning potential. Moreover, efficiency ratios represent the company’s aptness to generate
income from its assets and liabilities. These aspects of the business are crucial for its growth
and sustainability. However, to better understand a company’s financial well-being, it is also
essential to evaluate its capacity to meet its long-term financial liabilities.
Essential Question
What financial decisions are informed by solvency ratios?

Solvency Ratio
Solvency refers to a company's capacity to address its long-term debts and financial
obligations. These long-term debts mature in more than one year and have higher interest
rates. Hence, it is vital to know whether a company would have financial strength in the long
run.
Solvency is measured through the solvency ratio, which compares a firm's profitability with
its long-term obligations. More specifically, it determines whether the business's cash flow is
sufficient to pay its liabilities. The main formula for calculating a firm’s solvency ratio is:
The acceptable solvency ratio may differ from one industry to another. Generally, a 20%
solvency ratio is acceptable; anything lower than this may indicate the risk of default on
obligations.
The solvency ratio differs from the liquidity ratio, which compares the firm's current and
liquid assets with its current liabilities. The liquidity ratio determines the value of liquid assets
and whether these are enough to cover the firm's obligations that will mature in 12 months
or less.
Uses of Solvency Ratio

The solvency ratio is useful for internal and external stakeholders who are interested in a
company’s financial health. It would be unwise for the business entity to take on long-term
debt with high-interest rates without first examining whether the firm is profitable enough to
follow the payment schedule. Financial managers can use it to identify problem areas and
formulate strategies.

Lenders and investors would want to look into the firm's solvency ratio before letting it
borrow a large fund. Creditors can assess whether the business can pay them back if it
borrows funds. For instance, a 20% solvency indicates that the firm may take about five years
( ) to repay all its obligations.
Hence, the solvency ratio helps investors discern if the company is worth their resources,
while managers can identify problems and formulate strategies.
Limitation of Solvency Ratio

A high solvency ratio indicates financial strength, while a low ratio may mean financial risks in
the future. However, interested parties should analyze the solvency ratio alongside other
financial ratios to understand the entity's financial performance and health. For instance, a
company with a low solvency ratio may still cover its long-term obligations through equity
financing or the selling of shares to investors.
Closer Look
The Business Loans

Whenever a business applies for loans to finance its activities or acquire
investments, the bank typically requires it to submit copies of its financial
statements. Once the bank has collected the documents, it examines the
amounts reflected for the assets, liabilities, and equity. These numbers
are used to compute financial ratios such as solvency ratios, which
describe the capacity of the business to pay for its long-term financial
obligations, an essential consideration in approving the application for a
loan.

Check Your Progress
In what way/s can debt be beneficial to a company?

_________________________________________________________________________________
_________________________________________________________________________________
_________________________________________________________________________________
Types of Solvency Ratios

Like the other financial ratios, there are several types of solvency ratios that a company can
use to interpret data and determine solvency. Figure 1 shows the common solvency ratios
used by most companies.
Figure 1. There are various types of ratios used to assess a company’s solvency.
Equity-to-Assets Ratio
The equity-to-asset ratio reflects how much a company's equity funds are compared to its
liabilities. To compute for equity-to-assets ratio or equity ratio, divide the total equity by the
total assets as shown in this formula:

This solvency ratio shows the company's financial strength when its owners finance its
resources. An equity ratio greater than 50% implies that the company greatly relies on the
funds from its owners or stockholders. It is considered a conservative approach to
maintaining a healthy financial position since a higher equity ratio indicates that there are
fewer debts to pay. Although a higher equity ratio is seen as a healthy financial standing, this
may also suggest that the management decisions are divided among the stockholders. The
opposite of the conservative approach is the aggressive approach, wherein the equity ratio
is lower than 50%. It indicates that the firm relies heavily on debt financing.
Check Your Progress
What does a high equity-to-assets ratio imply?

_________________________________________________________________________________
_________________________________________________________________________________
_________________________________________________________________________________
Debt-to-Assets Ratio
The debt-to-assets ratio or debt ratio shows a company’s leverage. It reflects how much of
the company is funded by debt instead of assets. This solvency ratio is instrumental in
gauging the company’s capacity to settle its financial obligations through its available assets.
The debt-to-assets ratio is computed by dividing the total liabilities by the total assets, as
shown in this formula:
It is necessary to pay attention to how high or low the debt-to-assets ratio is, as this solvency
ratio reflects how a company is exposed to bankruptcy risk. When a company has a high debt
ratio, most of its assets are financed by debts or loans. Companies that rely heavily on debt
financing need consistent profitability to pay for principal and interest amounts. If they fail,
there is a great risk of bankruptcy.

On the one hand, if a company has a lower debt ratio, it is more likely to meet its financial
obligations. It also signifies that the company is exposed to lesser bankruptcy risk.
In some cases, it is also useful to analyze the long-term-liability-to-assets (LLR) ratio, which
shows the percentage of total assets financed by long-term debt. It gives insight into the
company's financial health in the long term. The formula for calculating the LLR ratio is:
Generally, an LLR ratio of less than 50% indicates good fundamental financial health. A higher
LLR ratio may mean that the company is at greater risk, especially when profitability declines.
Check Your Progress
Is it possible for a business to have a healthy financial standing while its

debt-to-assets ratio is high?
_________________________________________________________________________________
_________________________________________________________________________________
_________________________________________________________________________________
Debt-to-Equity Ratio
The debt-to-equity ratio shows the proportion of a firm's debts to its equity. This type of
solvency ratio measures how much of the debt can be paid using the company's equity. The
debt-to-equity ratio is computed by dividing the total liabilities by the total shareholder's
equity, as shown in this formula:

This solvency ratio reflects the firm's financing decisions regarding its capital structure, which
is a part of the financial analyst's responsibility. A debt-to-equity ratio exceeding 100% implies
that the business decided to get its funding through debts and loans. When debts are used to
sustain the business's operations, they must also pay operating expenses (i.e., interest
expense from the loan) to get financial leverage. Although it benefits the firms, it also exposes
the business to risks.
When the debt-to-equity ratio is less than 100%, it implies more equity financing than debt
financing. It means that the portion of assets provided by stockholders is more significant
than the portion of assets provided by creditors.
Moreover, when the ratio is equal to 100%, it indicates that creditors and stockholders equally
contribute to the business's assets.
Similar to the other types of solvency ratios previously discussed, it is important to note how
high or low the debt-to-equity ratio is. The higher the ratio, the more liabilities that a company
needs to settle, which means that there is a chance that the business may not be able to pay
all its debts.
Check Your Progress
How does debt financing affect the debt-to-equity ratio of a firm?

_________________________________________________________________________________
_________________________________________________________________________________
_________________________________________________________________________________

Analysis and Interpretation of Solvency Ratios

Now that you are familiar with the definition and function of solvency ratios, you may now
examine the following illustrative case to learn how to calculate, analyze, and interpret these
ratios. For the succeeding section, suppose that Benny Enterprise acquired a long-term loan
to invest in acquiring a small parcel of land and office space. Examine its Statement of
Financial Position and Statement of Financial Income shown in the Appendix.
Solvency Ratio
Based on the information from Benny Enterprise in Appendix A, what is the solvency ratio for
the year 2021?
Step 1: Determine the given relevant information and values.

Net income (2021) ₱140,000.00
Total Liabilities (2021) ₱664,800.00
Step 2: Determine what is asked.

You are asked to calculate and interpret Benny Enterprise’s solvency ratio for 2021.
Step 3: Provide the formula.
Step 4: Show your solution in computing for the unknown.
Step 5: Interpret your answer.

The enterprise's solvency ratio in 2021 is 21.05%. It is slightly higher than the 20%

acceptable solvency ratio. Thus, the enterprise is considered financially strong and
can pay its obligations approximately four years.
Equity-to-Asset Ratio
Based on the information from Benny Enterprise in Appendix A, what is the equity-to-asset
ratio for the year 2021?

Total equity ₱205,200.00
Total assets ₱870,700.00

You are asked to calculate and interpret Benny Enterprise’s equity-to-asset ratio for
2021.

The enterprise's equity ratio for 2021 is 23.57%. It indicates that the enterprise relies
more on funds acquired from loans. It also shows that the company has a large debt
to pay.

Debt-to-Asset Ratio
Based on the information from Benny Enterprise in Appendix A, what is the debt-to-asset

Total liabilities ₱664,800
Total assets ₱870,700

You are asked to calculate and interpret Benny Enterprise’s debt-to-asset ratio for
2021.

The enterprise’s debt ratio for 2021 is 76.35%. It indicates that the company relies
heavily on debt financing. The company must be consistently profitable to avoid
bankruptcy.
Debt-to-Equity Ratio
Based on the information from Benny Enterprise in Appendix A, what is the debt-to-equity


Total liabilities ₱664,800.00
Total equity ₱205,200.00

You are asked to calculate and interpret Benny Enterprise’s debt-to-equity ratio for
2021.

The enterprise’s debt-to-equity ratio for 2021 is 323.98%. It indicates that the
enterprise decided to pursue debt financing over equity financing. Creditors
contribute more to the company’s assets than the owner.

Keep in Mind
● A solvency ratio is a key metric that determines whether a company can meet its
long-term liabilities.
● There are different solvency ratios commonly used by most companies, such as
equity-to-assets ratio, debt-to-asset ratio, and debt-to-equity ratio.
● The equity-to-assets ratio, also referred to as the equity ratio, reflects how much of a
company is funded by the equity compared to liabilities.
● The debt-to-assets ratio or the debt ratio reflects how much of the company is funded
by debt instead of assets.
● The debt-to-equity ratio also shows how much of the company is funded by debt
instead of equity.

Try This
A. Short-Answer Response. Write the correct answer in the provided space.
________________ 1. It describes the company’s capacity to pay its long-term debts

and financial obligations.
________________ 2. It is a type of financial ratio used to assess a company’s ability to

meet its long-term liabilities.
________________ 3. This type of solvency ratio reflects how much of a company is

funded by equity in contrast to liabilities.
________________ 4. This type of solvency ratio is computed by dividing the total

liabilities by the total assets.
________________ 5. This type of solvency ratio evaluates how much of the debt can
be paid using the company’s equity.
B. True or False. Write true if the statement is correct. Otherwise, write false.
_______________ 1. Companies may sometimes resort to obtaining long-term loans

to acquire investments.
_______________ 2. The debt-to-equity ratio is the result of dividing the total liabilities
by the total shareholder’s equity.
_______________ 3. A low equity ratio means that the company has more debts than
equity.
_______________ 4. The debt-to-assets ratio reflects a company’s leverage.
_______________ 5. A low debt-to-assets ratio may mean that the company is less
likely to meet its financial obligations.

Practice your Skills

Analyzing Solvency
Solve for the solvency ratios of ABC Corporation. Refer to the Statement of Comprehensive
Income and Statement of Financial Position they submitted for the year 2021.
ABC Corporation
Statement of Comprehensive Income
For the Years Ended December 31, 2021
Net Sales 9,200,000

Less: Cost of Goods Sold 5,400,000
Gross Profit ₱ 3,800,000
Less: Operating Expense 320,000

Net Income ₱ 3,480,000
ABC Corporation
Statement of Financial Position
As of December 31, 2021
Current Assets ₱ 63,400,000

Noncurrent Assets 133,600,000
TOTAL ASSETS ₱ 197,000,000
Current Liabilities 75,000,000

Noncurrent Liabilities 119,100,000
TOTAL LIABILITIES ₱ 194,100,000
Stockholders’ Equity 2,900,000
TOTAL LIABILITIES AND EQUITY ₱ 311,200.00

1. Calculate ABC Corporation’s solvency ratio. Provide a short interpretation of the

result.
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
2. Calculate ABC Corporation’s equity-to-assets ratio. Provide a short interpretation of

the result.
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________

3. Calculate ABC Corporation’s debt-to-assets ratio. Provide a short interpretation of the

result.
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
4. Calculate ABC Corporation’s long-term-liabilities-to-assets ratio. Provide a short

interpretation of the result.
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________

5. Calculate ABC Corporation’s debt-to-equity ratio. Provide a short interpretation of the

result.
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
Challenge Yourself
Short Answer Response. Answer the following questions briefly and concisely.
1. Assume that your aunt owns a sari-sari store. Since you are an ABM student, she
asked you to prepare her business's financial statements for a loan purpose. You then
noticed that her debt ratio is 73%. How will you explain the importance of computing
the debt ratio to get her loan approved?
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________

2. According to the World Bank, the lending interest rate of the Philippines in 2019 is
7.1% per annum. If the interest rate is projected to increase to 7.8% per annum in
2023, how can this affect a company's debt ratio with long-term debt?
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
3. What advice will you give to a new businessman who plans to establish a corporation
and finance his capital structure with 100% equity?
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
___________________________________________________________________________________________
Photo Credit
Agroindustria-6940 by UNIDO is licensed under CC BY via Flickr.
Bibliography
Bragg, Steven. Accounting Reference Desktop. New York: John Wiley & Sons, 2002.
http://www.untag-smd.ac.id/files/Perpustakaan_Digital_1/ACCOUNTING%20Accountin
g%20Reference%20Desktop.pdf

Furhmann, Ryan. Analyzing Investments With Solvency Ratios. Accessed April 16, 2022.
https://www.investopedia.com/articles/investing/101613/analyzing-investments-solve
ncy-ratios.asp
Corporate Finance Institute. Solvency Ratio. Accessed April 16, 2022.

https://corporatefinanceinstitute.com/resources/knowledge/finance/solvency-ratio/

Appendix
Statement of Comprehensive Income and Financial Position
Benny Enterprise
Statement of Comprehensive Income
For the Years Ended December 31, 2020 and 2021
2020 2021
Net Sales 450,000.00 400,000.00
Less: Cost of Goods Sold 230,000.00 200,000.00
Gross Profit ₱ 220,000.00 200,000.00
Less: Operating Expense
Selling Expenses 43,000.00 43,000.00
Administrative Expenses 17,000.00 17,000.00
Net Income ₱ 160,000.00 140,000.00
Benny Enterprise
Statement of Financial Position
As of December 31, 2020 and 2021
December 31, 2020 December 31, 2021

Current Assets
Cash ₱ 43,000.00 40,000.00
Accounts Receivable 130,000.00 120,000.00
Marketable Securities 7,500.00 7,500.00
Inventories 21,200.00 19,200.00
Supplies 3,000.00 4,000.00
Prepayments 14,300.00 16,000.00
₱ 219,000.00 206,700.00

Noncurrent Assets
Land ₱ 40,000.00 300,000.00
Building, net 38,200.00 350,000.00
Intangible Assets 14,000.00 14,000.00
92,200.00 664,000.00
TOTAL ASSETS ₱ 311,200.00 870,700.00
Current Liabilities
Accounts Payable ₱ 40,000.00 40,000.00
Notes Payable 21,900.00 21,900.00
Wages Payable 18,000.00 18,000.00
Rent Payable 15,000.00 15,000.00
94,900.00 94,900.00
Noncurrent Liabilities
Long-term loan 558,800.00
Long-term notes payable 11,100.00 11,800.00
TOTAL LIABILITIES ₱ 106,000.00 664,800.00
Owner’s equity
Benny, Capital 205,200.00 205,200.00
TOTAL LIABILITIES AND EQUITY ₱ 311,200.00 870,700.00

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Unit 2: Financial Statement: A Review

Learn the Basics 4

Practice your Skills 17

Financial Ratios: Solvency

2.5 Financial Ratios: Solvency 1

Learning Objectives DepEd Competencies

● Deﬁne the measurement levels; namely,

● Discuss the diﬀerent solvency ratios. ratios (ABM_BF12-IIIb-9).

● Compute for various solvency ratios.

● Interpret solvency ratios.

2.5 Financial Ratios: Solvency 2

2. Do you think long-term debts are bad? Why or why not?

2.5 Financial Ratios: Solvency 3

Cite examples to illustrate your point.

Learn the Basics

What ﬁnancial decisions are informed by solvency ratios?

2.5 Financial Ratios: Solvency 4

Uses of Solvency Ratio

2.5 Financial Ratios: Solvency 5

Limitation of Solvency Ratio

The Business Loans

2.5 Financial Ratios: Solvency 6

Check Your Progress

In what way/s can debt be beneﬁcial to a company?

Types of Solvency Ratios

2.5 Financial Ratios: Solvency 7

Check Your Progress

What does a high equity-to-assets ratio imply?

2.5 Financial Ratios: Solvency 8

Check Your Progress

Is it possible for a business to have a healthy ﬁnancial standing while its

2.5 Financial Ratios: Solvency 9

Check Your Progress

How does debt financing affect the debt-to-equity ratio of a firm?

2.5 Financial Ratios: Solvency 10

Analysis and Interpretation of Solvency Ratios

Step 1: Determine the given relevant information and values.

Step 2: Determine what is asked.

Step 3: Provide the formula.

Step 4: Show your solution in computing for the unknown.

Step 5: Interpret your answer.

2.5 Financial Ratios: Solvency 11

Step 1: Determine the given relevant information and values.

Step 2: Determine what is asked.

Step 3: Provide the formula.

Step 4: Show your solution in computing for the unknown.

Step 5: Interpret your answer.

2.5 Financial Ratios: Solvency 12

Step 1: Determine the given relevant information and values.

Step 2: Determine what is asked.

Step 3: Provide the formula.

Step 4: Show your solution in computing for the unknown.

Step 5: Interpret your answer.

2.5 Financial Ratios: Solvency 13

Step 1: Determine the given relevant information and values.

Step 2: Determine what is asked.

Step 3: Provide the formula.

Step 4: Show your solution in computing for the unknown.

Step 5: Interpret your answer.