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Solvency Ratio: Definition, Type, and Calculation Formula

Timesofummah.com – Solvency ratio is a comparison of several measures which are generally expressed by numbers. One of the solvency that is generally used in measuring the finances of insurance companies is in good health or not. Check out a more complete explanation of the Solvency Ratio starting from the Definition, Types, Benefits, Calculation Formulas and Books Related to Solvency Ratios:

Understanding Solvency Ratio

Solvency Ratio Definition, Type, and Calculation Formula

The solvency ratio is a ratio that functions to assess the company’s ability to pay off all its obligations, both in the short and long term with the guarantee of assets or assets owned by the company so that the company is liquidated or closed. Thus, customers of long-term insurance products such as life insurance products can then assess the company before choosing it. The solvency ratio, solvency ratio or leverage ratio then compares the company’s overall debt burden to equity and assets.

This ratio will describe the number of company assets owned by a shareholder compared to assets owned by creditors or creditors. If more of the company’s assets are owned by shareholders, then the company will then experience less leverage. If the lender or creditor usually the bank in this case has the dominant asset, the company will then have a higher level of leverage.

Solvency itself is the ability of a company to pay off all debts by using assets as debt guarantor which is the basic concept of accounting. The company’s solvency will also reflect the company’s ability to repay or repay all loans through the amount of assets owned. This ability will also affect the financial statements of a company.

Types of Solvency Ratios and their Calculation Formulas

There are three types of solvency ratios, including debt to equity ratio, debt ratio, and times interest earned ratio. Check out a more complete explanation below:

1. Debt to Equity Ratio (Ratio of Debt to Equity)

Formula: Debt to Equity Ratio (DER) = Total Debt / Equity (Capital) x 100%

This ratio will describe the relative portion between debt and equity which is then used to finance the company’s assets. Debt to equity ratio or Debt to Equity Ratio (DER) will also compare total equity (equity) and liabilities. The amount of debt itself must not be greater than the capital so that the company’s burden does not increase. A low ratio level also means that the company’s condition is improving because the portion of debt to capital is getting smaller. This ratio will also show loan funds that are due soon and will be billed when compared to the capital owned. The calculation of this ratio aims to find out how much capital is needed, including the types of capital and the understanding of the capital that is guaranteed for current debt. The smaller the ratio, the better the company’s condition will be because the capital will then guarantee that current debt is still in a sizeable portion. The lowest limit of the ratio itself is 100% or 1:1.

2. Debt Ratio (Debt Ratio)

Formula: Debt Ratio = Total Debt / Total Assets x 100%

Debt ratio or debt ratio will also assess how much the company is based on debt in financing assets. This ratio will also compare the total debt (liabilities) with the total assets owned. Assets and equity themselves are two different things, so we must know in advance about assets and equity, then the company’s assets as resources obtained from other activities or transactions in the past so that they belong to the company. Meanwhile, equity is the residual interest in the company’s assets after deducting all liabilities in accordance with the nature of the accounting.

This ratio will also show the company’s ability to obtain new loans as collateral for fixed assets to be owned by a company as well as additional capital. If the level of this ratio increases, then the guarantee of existing assets and the money provided by creditors in the long term are increasingly guaranteed.

The percentage of this ratio is usually at a minimum of 100% or 1:1. That is, Rp.1 long-term debt can then be secured by Rp. 1 fixed assets owned by the company. Debt calculated in this case is all company debt, both long-term and short-term. Creditors usually prefer a low debt ratio because the condition of the company is in a safe condition so it has the opportunity not to go bankrupt. The lower the ratio, the more secure or solvable the company’s condition is.

3. Times Interest Earned Ratio

Formula: Times Interest Earned Ratio = Profit Before Tax and Interest / Interest Expense x 100%

This ratio is also known as the interest coverage ratio which will then measure the company’s ability to pay off various debt interest expenses in the future. This ratio will also compare interest to interest expense in accordance with accounting principles and profit before tax.

Solvency Ratio Benefits

There are several benefits to the company by using the solvency ratio, including this ratio will make it easier for investors and management to understand the level of risk of the company’s capital structure by going through the notes on a financial report. The benefits of the solvency ratio itself are as follows:

  • Analyze the company’s position when viewed from its debt obligations.
  • Useful in knowing the extent to which the company is able to meet its debts and interest.
  • Useful in terms of reviewing the balance of the value of assets (assets) against the company’s capital.
  • Useful in making it easy to find out how much of a company’s assets are backed by debt.
  • Useful in order to analyze the effect of debt on asset management.
  • Useful in terms of ease of knowing how much of the company’s capital portion is used as a guarantee for long-term debt.
  • Useful in knowing the amount of loan funds that will soon be billed or due for a company’s capital.
  • Summarizing Financial Conditions, Companies To Creditors The calculation of the solvency ratio is one of the crucial activities for the company’s reputation in the eyes of creditors. The meaning is not limited to the debtor only
  • Company creditors who need solvency data include money borrowing institutions, factoring companies to receivables, investors, as well as insurance. If the solvency level of a business is at a low level, these creditors will then doubt the company and put it on the blacklist.
  • It also serves to assess the ability of a business to pay interest – One of the consequences of transacting on credit is interest, which then applies between the creditor and the company. In addition, in assessing the company’s capacity to pay solvency ratios, debt, is a powerful tool in projecting business capabilities, as well as paying interest for the next few years.
  • Providing Information on Health A healthy financial balance with balanced assets and capital is a breath of fresh air for the company’s creditors.
  • One of the data on the health of this balance sheet can be obtained through solvency calculations.
  • Estimated Total Loans at Maturity – Payment The final objective of calculating the solvency ratio is so that creditors can find out the total amount of money to be obtained from the company’s credit payments. This estimate of total payments is also especially important if the lender is promised repayment of the loan with interest or dividend development.

Solvency Ratio Formula

To better understand what solvency is and its practical calculation, below is an explanation of the solvency ratio formula and an example of its calculation:

1. Debt to Asset Ratio

The solvency formula for the D/E Ratio itself is very simple, including the total debt (debt) divided by the company’s total assets (assets). If the value of the D/A Ratio is more than 1.0, it means that the company’s solvency is in trouble.

Example:
A has total unpaid liabilities of Rp.207 billion, with total assets he currently has of Rp.200 billion. Thus, the calculation is:
Solvency ratio formula D/A = debt/assets
Solvency of D/A PT. A = Rp. 207 billion/Rp. 200 billion = 1,035

So, the solvency of PT. A is among 1,035, which means having the ability to pay the company’s obligations at this stage is problematic, although at a low level.

2. Debt to Equity Ratio

The formula for a solvency D/E ratio is almost the same as a D/A ratio, only differs in the accumulation of equity. The optimal value of the D/E ratio itself is 2.0.

Example:
Owner of PT. B has equity in the company of IDR 100 billion out of total assets of IDR 250 billion (which means IDR 150 billion comes from debt). Meanwhile, other obligations include PT. B if the total is Rp. 25 billion. So in terms of D/E PT. B by calculating the solvency ratio of which are as follows:
Solvency ratio formula D/E = debt/equity
Solvency of D/E PT. B
= (Rp150 billion + Rp25 billion)/Rp100 billion
= IDR 175 billion/ IDR 100 billion
= 1.75

So, the D/E solvency ratio of PT. B is 1.75, which means the ratio of total equity and debt is still below the maximum threshold.

3. Debt to Capital Ratio

Meanwhile, for the Debt to Capital Ratio, the following formula is the solvency D/C or leverage ratio which is slightly different from the D/A or D/E ratio. If you want to know your D/C ratio then you have to divide your total debt by your total wealth, whether it’s funded by debt or equity. There is no maximum limit for the D/C ratio, but the lower the nominal, the better.

Example:
C with a debt of IDR 100 billion, his total equity reaches IDR 150 billion. If you want to find the D/C ratio PT. C, the calculation is as follows:
Solvency ratio formula D/C = debt/(debt + equity)
Solvency of D/C PT. C
= IDR 100 billion/(IDR 100 billion + IDR 150 billion)
= Rp100 billion/Rp250 billion
= 0.4

This means, the debt ratio of PT. C is only 40% of the company’s total capitalization, so PT. C itself is still considered healthy and good in terms of solvency.

Differences in Solvency, Liquidity, & Viability

Basically, solvency is a comparison of the company’s total debt with assets owned, while liquidity is a comparison of how much current assets or cash owned by the company compared to its non-current assets. Lastly, viability is the ratio between solvency and liquidity.

A company is declared healthy if the level of liquidity is at least equal to the level of solvency. If solvency is higher than liquidity, then this company has an unhealthy financial condition. This requires a balance sheet restructuring or other financial strategy.

Book Recommendations Related to Solvency Ratio

1. Corporate Financial Strategy

This book is intended for companies that want ideal information on how to manage company finances. Can be used by corporate financial organizations, namely Directors, Managers, Supervisors and Staff, in academia it is used by students and lecturers to learn and add insight into how financial implementation is implemented.

By summarizing the author’s experience as a management accountant and public accountant, the author can share a lot of knowledge so that it can be added value for companies in need. The profession of public accountant who is the company’s external auditor who always provides findings and suggestions, of course the author can deepen it by placing himself as the “Doctor of the Company”. So that it becomes a more useful job if the knowledge gained can be written down into a recipe that is presented to companies in need.

2. Financial Management for Companies

Financial management means how to manage finances for productive things, which can provide profits for the company in the short, medium and long term. The book on Financial Management for Companies (Concepts and Applications) is a continuation of the book Fundamentals of Financial Management for Companies, which was previously published and circulated by the same publisher.

This book consists of ten chapters, namely The Evolution of Financial Theory, Functions and Objectives of Financial Management, Cash and Securities Management, Capital Markets, Business Mergers and Company Restructuring, Multinational Financial Management, Functions of Money and Capital Markets.

3. The twists and turns of Corporate Financial Strategy: A Practical Guide to Increasing Company Value

Talking about business, sometimes business is not just a way for someone to make a profit, so they can live well. More than that, business is a long learning process, and often painful. Through business, we learn many things, especially financial management. It is undeniable because in the end the purpose of business is, one of them, to support both oneself and others (family, employees, and others).

Good planning and money management will certainly bring benefits to business people, as well as companies. Even though there is a lot of knowledge about financial strategy, it doesn’t necessarily make business people successful, or certain knowledge doesn’t work for everyone. The ups and downs of a business are lessons for business people, from small scale to finally growing big.

Of course, business is also expected to provide added value to the economy; create jobs, for example. Therefore, the company actually needs a financial architect, namely someone who is an expert and able to manage finances positively. These financial architects, need reading material so that they have guidance in doing their work.

4. Fundamentals of Corporate Financial Management

The work of Mokhamad Anwar, PH.D., Mokhamad Anwar, Ph. D. This book specifically discusses corporate finance, which can be used and adjusted based on its scale for small companies, medium companies, and large companies. The purpose of financial management in a company (business) is intended so that the company can manage its resources, especially from the financial aspect, so as to produce maximum profit—profit oriented—which in turn can maximize the welfare of shareholders.

This book that comprehensively discusses “financial management” is very suitable for beginners who want to learn about the “financial management” of a business (business), especially for undergraduate, postgraduate, and Diploma students in understanding basic principles of corporate organizational management. However, this textbook can also be used as the main reference for entrepreneurs, both small and medium-sized businesses, in understanding the basic principles of financial management of a business (business).

This textbook on the basics of financial management presents 10 (ten sections) discussions on financial management: The Importance of Finance, Financial Institutions and Markets, Working Capital Management, Cash Management, Accounts Receivable Management, Inventory Management, Time Value of Money, Capital Budgeting, Cost of Capital, and Analysis Financial Statements (Financial Statement Analysis).

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