Solvency ratios ask a longer-term question than liquidity — how much of the business is financed by owners versus creditors, and how much risk (leverage) does that create?
1Solvency ratios measure the mix of debt vs. equity financing a business relies on.
2Equity Ratio = Owner's Equity ÷ Total Assets.
3Debt Ratio = Total Liabilities ÷ Total Assets.
4Equity Ratio + Debt Ratio always equal 100% of Total Assets.
5Higher leverage (more debt, less equity) means higher risk, but also the potential for higher returns to the owner.
Where liquidity ratios ask "can this business pay its bills next month?", solvency ratios ask a bigger question: "how much of this business actually belongs to the owner, versus how much is owed to creditors?" A business financed almost entirely by debt is riskier — its owners have less cushion if profits fall, and creditors have a much bigger claim on its assets if things go wrong.
The Equity Ratio describes the relationship between owner's equity and total assets — it shows what percentage of everything the business owns was actually financed by the owner's own investment, rather than borrowed. The Debt Ratio describes the relationship between total debts and total assets — the mirror image, showing what percentage was financed by creditors. Because every asset is financed by either debt or equity (that's the accounting equation itself: Assets = Liabilities + Owner's Equity), the Equity Ratio and the Debt Ratio always add up to exactly 100%.
Fig 1Equity ratio and debt ratio always sum to 100% of total assets
Leverage cuts both ways
Using borrowed money (leverage) to grow a business can amplify returns when things go well — the owner keeps all the extra profit after paying a fixed interest rate on the debt. But leverage amplifies losses just as sharply: interest still has to be paid even in a bad year, and a heavily leveraged business (a low equity ratio, a high debt ratio) has far less room to absorb a downturn before creditors start to worry about being repaid.
Worked examples
Reveal one step at a time and try to beat it to the next line.
Example 1
A company has Total Assets of $250,000 and Total Liabilities of $90,000. Find Owner's Equity, the Equity Ratio, and the Debt Ratio.
Example 2
Two companies both have Total Assets of $500,000. Company A has a Debt Ratio of 20%; Company B has a Debt Ratio of 70%. Which company is more leveraged, and which company's owner has more of their own money at risk in the business?
Where marks get lost
Forgetting that Equity Ratio and Debt Ratio must add up to exactly 100% of Total Assets — a wrong figure often shows up as a check failure here.
Assuming more debt is automatically bad — moderate, well-managed leverage is a normal and often smart financing strategy for a healthy business.
Using Current Liabilities instead of TOTAL Liabilities (current plus long-term) when calculating the Debt Ratio.
Confusing the Debt Ratio (a solvency measure, long-term view) with the Current Ratio (a liquidity measure, short-term view) — they answer different questions.
Flashcards 6
The Equity Ratio
Debt Ratio
Equity Ratio formula
Debt Ratio formula
+ 2 more
Practice
1
Total Assets $400,000; Total Liabilities $150,000. Find the Equity Ratio.
%
2
Total Assets $400,000; Total Liabilities $150,000. Find the Debt Ratio.
%
3
A business with a Debt Ratio of 80% is considered:
4
What two ratios always add up to 100% of Total Assets?
5
A company's Equity Ratio is 55% on Total Assets of $600,000. Find the dollar amount of Total Liabilities.
$
6
Leverage (using debt to finance a business) is risky mainly because: