Solvency Ratio

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Shashi Shankar H.S

Shashi Shankar H.S (Querist)
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15 May 2009 Hi All,

Can any one explain about Solency Ratio with formula.

Thanks in advance

CA CS CMA Srinivasan N

CA CS CMA Srinivasan N (Expert)
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15 May 2009 Hi,
Solvency ratios measure the financial soundness of a business and how well the company can satisfy its short- and long-term obligations.
Solvency Position is generally tested with many ratios rather than only the Liquid Ratio. The most commonly used are:

*Quick Ratio – This ratio, also called "acid test" or "liquid" ratio, considers only cash, marketable securities (cash equivalents) and accounts receivable because they are considered to be the most liquid forms of current assets. A Quick Ratio less than 1.0 implies dependency on inventory and other current assets to liquidate short-term debt. This ratio is calculated using the following formula:

Cash + Accounts Receivable ÷ Current Liabilities

*Current Ratio – This ratio is a comparison of current assets to current liabilities, commonly used as a measure of short-run solvency, i.e., the immediate ability of a business to pay its current debts as they come due. Potential creditors use this ratio to measure a company's liquidity or ability to pay off short-term debts. Thist ratio is calculated using the following formula:

Current Assets ÷ Current Liabilities

*Current Liabilities to Net Worth Ratio – This ratio indicates the amount due creditors within a year as a percentage of the owners or stockholders investment. The smaller the net worth and the larger the liabilities, the less security for creditors. Normally a business starts to have trouble when this relationship exceeds 80%. This ratio is calculated using the following formula:

Current Liabilities ÷ Net Worth

*Current Liabilities to Inventory Ratio – This ratio shows, as a percentage, the reliance on available inventory for payment of debt (how much a company relies on funds from disposal of unsold inventories to meet its current debt). This ratio is calculated using the following formula:

Current Liabilities ÷ Inventory

*Total Liabilities to Net Worth Ratio – This ratio shows how all of a company's debt relates to the equity of the owners or stockholders. The higher this ratio, the less protection there is for the creditors of the business. This ratio is calculated using the following formula:

Total Liabilities ÷ Net Worth

*Fixed Assets to Net Worth Ratio – This ratio shows the percentage of assets centered in fixed assets compared to total equity. Generally the higher this percentage is over 75%, the more vulnerable a concern becomes to unexpected hazards and business climate changes. Capital is frozen in the form of machinery and the margin for operating funds becomes too narrow for day-to-day operations. This ratio is calculated using the following formula:

Fixed Assets ÷ Net Worth

ALSO SEE THIS LINK FOR MORE INFO:
http://www.stocks-simplified.com/Solvency_Ratio.html

Rgds

chetan soni

chetan soni (Expert)
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15 May 2009 We can can also comment on solvency of company on the basis of above rations mentioned. But we can also derive the Solvency ration by following explanation.

One of many ratios used to measure a company's ability to meet long-term obligations. The solvency ratio measures the size of a company's after-tax income, excluding non-cash depreciation expenses, as compared to the firm's total debt obligations. It provides a measurement of how likely a company will be to continue meeting its debt obligations.

The measure is usually calculated as follows:

Solvency Ratio = (After tax profit+Depreciation) / (Long term liabilities + short term liabilities)

Acceptable solvency ratios will vary from industry to industry, but as a general rule of thumb, a solvency ratio of greater than 20% is considered financially healthy. Generally speaking, the lower a company's solvency ratio, the greater the probability that the company will default on its debt obligations.

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