Wednesday, August 17, 2011

About Long-Term Solvency Ratios

Long-term solvency ratios provide information about a company’s financial leverage.  They also measure a company’s ability to pay long-term obligations (those with maturities exceeding one year).  Two examples of long-term solvency ratios are the total debt ratio and the long-term debt ratio.

Total Debt Ratio
The total debt ratio measures the amount of debt a company uses.  Subtracting total equity from total assets then dividing the result by total assets yields the total debt ratio.  For example, if Company A has $3,691 in total assets and $2,467 in total equity, its total debt ratio is 0.33 times ($3,691 - $2,467 / $3,691).  In other words, Company A uses 33 percent and has more assets than debts, which means the company does not rely on debt to operate.

Long-Term Debt Ratio
Long-term debt ratios measure a company’s financial leverage, debt used by a firm to support its capital structure.  The long-term debt ratio is calculated by dividing long-term debt by the result of long-term debt plus total equity.  For example, if Company B has $557 in long-term debt and $2,667 in total equity, its long-term debt ratio is 0.17 times ($557 / $557 + $2,667).   As a result, Company B has less than 17 percent of debt with maturities lasting longer than one year.  Additionally, the company’s assets far exceed its liabilities.

Reference
"Fundamentals of Corporate Finance", Stephen Ross, 2008




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