Analysis of Long Term Solvency

>> December 1, 2011

Like analysis of short term solvency, we also analyze our long term solvency. Solvency's dictionary meaning is the power to repay the loan. If we have sufficient amount in our pocket, we can repay loan at any time. But long term solvency meaning is very large. Some loan of $ 10 million which we have to pay after 5 years and other other loan is of  $ 20 million which we have to pay after 10 years. All these loans are long term which are the main part of our long term liabilities. Analysis of long term solvency will tell us our power to repay all these long term liabilities through our long term assets. Suppose, we have $ 20 Million's trucks whose value will be $ 10 million, it means, we have capacity to repay $ 10 million after 5 years by selling our trucks of same amount. This is a simple analyze which you are doing of your single man transport business. Now, this a big MNC or any other company who has billions of assets and liabilities. But these companies also face the losses because these companies do not care on long term solvency.

If your all long term assets have no capacity to pay your all long term liabilities, it means there is big need to take big decisions. We all know our long period converts in to short period. So, if we see any default relating to long term solvency, we should not ignore it.

There are lots of accounting ratios which can be used for analysis of long term solvency but here we are discussing two important ratios.

1. Fixed Assets to Long Term Debt Ratio 

(a) From above ratio, we can estimate that these fixed assets are bought from long term debt. We have current 80% repayment capacity through these fixed assets. 

(b) If fixed assets ratio is 100%, then it is good because we have capacity to clear our 100% long term debts. 

(c) If fixed assets ratio is 130%, it means we have fixed assets of 30% which we bought from our short term fund, this long term solvency is not good because at that time we are using our short term funds for long term assets. At that time, our short term financial position may be affected from this. 

2. Fixed Assets to Share Capital Fund Ratio

This ratio is relationship between fixed assets and share capital fund. This ratio is also called fixed assets to net worth ratio. Following is its formula:

= Fixed Assets / Share capital fund

For example, if fixed asset is 400,000 just like in above example, before calculating fixed asset ratio, we will calculate fixed assets to net worth ratio. Suppose, our share capital is Rs. 400,000, at that time this ratio will be

= 400000 /400000 X 100 = 100%. 

It means all these fixed assets are bought from our share capital. But if fixed assets are Rs. 500,000, at that time, we have to demand RS. 1,00,000 from more debt which will increase our cost.

Why do We Calculate Assets ratio with Assets to Net Worth Ratio?

Suppose, our Rs. 400,000 becomes Rs. 0 due to high decrease of share market prices. At same time, if our total fixed assets are just 50% of total long term debt. How will we manage balance of 50%? So, it is very necessary to calculate all type of long term solvency ratio and be secure.  

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