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A firm’s solvency position can be best studied with the help of group of ratios called as Solvency Ratios. These ratios measure the financial position of the firm by measuring its ability to pay long term liabilities, these long term liabilities include principal amount payments on due date and interest payments on a regular basis. Following ratios are used to determine long term solvency of a business.
1. Debt-Equity Ratio: This ratio shows the relationship between owner funds (equity) and borrowed funds (debt). A lower debt-equity ratio provides more security to the people who are lending to the business. It also shows that a company is able to meet long term dues or responsibilities.
2. Total Assets to Debt Ratio: It is based on the relationship between total assets and long term loans. It shows what percentage of company’s total assets are financed by creditors. A higher total assets to debt ratio makes the firm able to meet long term requirements and provides more security to lenders.
3. Interest Coverage Ratio: This ratio is used to determine the easiness with which a company is able to pay interest on the outstanding debts. It is calculated by dividing earnings before interest and taxes with interest payments. Having a higher interest coverage ratio means that company is able to meet its obligations skilfully.
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d. Proprietary Ratio– This ratio shows the relationship between Total Assets and Shareholders fund. It is helpful in revealing the financial position of a business. A higher ratio ensures a greater degree of security for creditors. It is shown as: