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# Liquidity and Solvency
Solvency Ratios help investors evaluate the competence of a company to meet its long term debt obligations. Liquidity Ratios are used to evaluate the ability to pay off short term debt obligations.

## Debt to Equity Ratio
The Debt to Equity ratio tells us how much a company's debt weighs against its
shareholders equity. It gives us an overview of a company's capital structure
by measuring the amount of employed debt against equity.

The Debt to Equity ratio can be defined as

Debt to Equity Ratio = Total Debt / Shareholders Equity

We'll consider total debt as the sum of financial obligations which bear
interest and lease liabilities. This includes current and non-current
borrowings, lease liabilities, current maturities of long term debt and lease
obligations, and any other liabilities that can bear interest. We will **NOT**
consider trade payables, provisions, and deferred tax liabilities for
calculating the total debt. Keeping this in mind, we can define total debt as,

Total Debt = Current Borrowings + Non-current Borrowings + Lease Liabilities + Current Maturities of Long Term Debt and Lease Liabilities + Other Interest Bearing Obligations

We can also restrict total debt to non-current borrowings and other interest
bearing non-current financial obligations only depending upon the company we're
analyzing. In such cases, we're primarily concerned with the non-current
financial obligations of the company in comparison to the shareholders equity.

We've already defined shareholders equity before as total assets minus total
liabilities. It can also be found on the balance sheet in an annual report.


> Part 2 of the Balance Sheet of Larsen & Toubro Ltd for the year 2020

Let's consider the balance sheet of Larsen & Toubro, one of the biggest
construction companies in the world.

The total debt can be calculated as `₹35,021.02 + ₹23,654.77 + ₹82,331.33 +
₹1,741.6 + ₹424.95 = ₹1,43,173 crores`. The Shareholders Equity is `₹280.78 +
₹66,442.44 = ₹66,723 crores`. `<---` needs clarification

Although we've included lease liabilities in our calculation, not being able to
pay lease obligations may not have the same impact as not paying loan
obligations. We can exclude lease obligations from the numerator to get a debt
to equity ratio of `2.11`.

A debt to equity ratio of `2.14` tells us that for every ₹1 in shareholders
equity, Larsen & Toubro has `₹2.14` in debt.

Usually, a higher value of debt to equity ratio indicates higher insolvency
risk compared to another company with a lower value. Although this may be
correct but the assumption that comes attached — a company with a higher debt
to equity ratio is unequivocally not going to stay solvent - isn't always true.
This is because a company's financial ability to cater to its debt obligations
needn't be stuck solely in shareholder's equity.

As we've said before, ratios are meaningless when looked at in isolation. Let's
calculate the debt to equity ratio of another construction company, Reliance
Infrastructure Ltd.

> Part 2 of the Balance Sheet of Reliance Infrastructure Ltd for the year 2020

> Note 11(d) of the financial statements of Reliance Infrastructure for the year 2020

We've showcased Note 11(d) from Reliance Infra's financial statements because
it contains figures for the premium payable to National Highways Authority of
India (NHAI). NHAI premiums are payments made by construction companies to NHAI
in build, operate, and transfer (BOT) projects. We're considering NHAI premiums
as a component of total debt. The total debt can be calculated as `₹11,758.86 +
₹2,541.37 + ₹2,765.28 + (₹272.31 + ₹2,206.92) + ₹13.98 + ₹67.61 = ₹19,626.33
crores` and the Shareholders Equity is `₹9,792.37 crores`. This gives a debt to
equity ratio of `2`.

Note that comparing the debt to equity ratio of companies from different
sectors or industries isn't helpful and often misleading. Simply put, different
sectors, or industries, have different operational and financial aspects. IT
companies are generally cash rich and don't require a lot of capital compared
to construction companies so it makes sense that the debt to equity ratio of IT
companies would be lower than that of banks & non-banking financial companies
(NBFCs) whose business model depends entirely on borrowing money from one
entity and loaning it to another.

Another thing to keep in mind is that companies at different stages of their
business cycle may have varied debt to equity ratios, so comparing their values
may not be perfectly intuitive. One company may be in its expansion stage while
another may be focusing on winding down its debt. Companies of different scales
may also yield varied debt to equity ratios. This is because cost of debt is
often dependent on a company's size and can affect a company's decision to take
on more or less debt.

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1: [National National Highways Authority of India allows premium rejig for 9 highway developers](https://economictimes.indiatimes.com/news/economy/infrastructure/national-highways-authority-of-india-allows-premium-rejig-for-9-highway-developers/articleshow/35520738.cms) | [archive.org link](https://web.archive.org/web/20210322162109/https://economictimes.indiatimes.com/news/economy/infrastructure/national-highways-authority-of-india-allows-premium-rejig-for-9-highway-developers/articleshow/35520738.cms) | [archive.is link](https://archive.is/pxnrO)