To assess the long term solvency of the business, which of the following ratios are needed?

(A) Interest coverage ratio

(B) Proprietary ratio

(C) Acid test ratio

(D) Debt to capital employed ratio

Choose the correct answer from the options given below:

(A), (B) and (D) only

The correct answer is option 1- (A), (B) and (D) only.

Except (C) Acid test ratio, all others are used to assess the long term solvency of the business.

Solvency ratios focus on assessing a business's capability to fulfill its long-term debt obligations rather than short-term ones. The persons who have advanced money to the business on long-term basis are interested in safety of their periodic payment of interest as well as the repayment of principal amount at the end of the loan period. Solvency ratios are calculated to determine the ability of the business to service its debt in the long run. The following ratios are normally computed for evaluating solvency of the business. 1. Debt-Equity Ratio; 2. Debt to Capital Employed Ratio; 3. Proprietary Ratio; 4. Total Assets to Debt Ratio; 5. Interest Coverage Ratio.

(A) Interest coverage ratio- It is a ratio which deals with the servicing of interest on loan. It is a measure of security of interest payable on long-term debts. It expresses the relationship between profits available for payment of interest and the amount of interest payable. It is calculated as follows:
Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long-term debts.
It reveals the number of times interest on long-term debts is covered by the profits available for interest. A higher ratio ensures safety of interest on debts.

(B) Proprietary ratio- Proprietary ratio expresses relationship of proprietor’s (shareholders) funds to net assets. Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets instead of net assets (capital employed). It may be noted that the total of debt to capital employed ratio and proprietory ratio is equal to 1. 

(C) Acid test ratio- It assesses the short term solvency not long-term. Quick or Liquid Ratio is the ratio of quick (or liquid) asset to current liabilities. The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets. Because of exclusion of non-liquid current assets it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’.

(D) Debt to capital employed ratio- The Debt to capital employed ratio refers to the ratio of long-term debt to the total of external and internal funds (capital employed or net assets). It shows proportion of long-term debts in capital employed. Low ratio provides security to lenders and high ratio helps management in trading on equity. In the above case, the debt to Capital Employed ratio is less than half which indicates reasonable funding by debt and adequate security of debt.