In part two of this series we looked at Liquidity ratios, and in this article we will look at solvency or leverage ratios. Liquidity refers to a company’s ability to pay short-term obligations, as well as its ability to sell assets in order to quickly raise cash. Solvency refers to an company's capacity to meet its long-term financial commitments.
Solvency and liquidity are both indicative of a company’s state of financial health and should be evaluated equally despite having marked differences. A solvent company is one that owns more than it owes; it has a positive net worth and a manageable debt load. On the other hand, a company with adequate liquidity may have sufficient cash available to pay its bills, but it still could be heading for financial disaster down the road.
With this in mind let's look more closely at Solvency or Leverage Ratios:
This group of ratios look at the extent to which a business has relied upon borrowing to finance its operations. These ratios are almost always among the analytics of a company reviewed by bankers and investors. Most of these ratios compare assets or net worth with liabilities. Higher ratios tend to increase a company's exposure to risk and setbacks in business revenues, but this higher risk may also signal the potential for higher returns.
The Solvency Ratio
The Solvency Ratio is the primary datametric of a company’s ability to meet its debt and other financial obligations. This ratio indicates if a company’s cash flow is sufficient to meet both short-term and long-term liabilities. The lower a businesses’ Solvency Ratio, the greater the probability that it will default on its debt obligations. The Solvency Ratio is computed as:
The Solvency Ratio is a comprehensive measure of solvency or leverage, because it measures cash flow – rather than net income – by including depreciation to assess a businesses’ capacity to stay afloat. This ratio measures the cash flow capacity in relation to all liabilities not just debt. Apart from debt the company’s other liabilities include short-term obligations like accounts payable and long-term liabilities such as capital leases and pension plan obligations make this a significantly broader measure.
Other Leverage Ratios
The solvency ratio is only one of the metrics used to determine whether a company can stay solvent. Other solvency ratios include the Equity Ratio, the Debt Ratio, and Debt Coverage ratios.
The Equity Ratio
The Equity Ratio is total equity divided by total assets. In a shareholder business we may find this expressed within the notes to the financial statements as the ‘Shareholders Equity Ratio’ in which the ratio equals total shareholders’ equity divided by total assets.
The Equity Ratio is indicative of the relative proportion of equity used to finance a company's assets. In most cases this ratio is computed from the company’s financial position reflected in the balance sheet, in these cases accountant’s will refer to the analytic as a ‘book value’ datametric; however, in cases where a business is publicly traded the ratio is typically computed using market values for the company’s equity.
If you are a stockholder in a company the Equity Ratio is a significant measure of your company’s value. A low equity ratio indicates that the company has acquired most of its assets through borrowing rather than by using its equity. In other words, rather than leveraging its equity position, it borrows to maintain operations.
The Debt Ratio
The Debt Ratio is Total Debt divided by Total Assets. The higher the ratio, the greater risk will be associated with the firm's operation; in addition, high debt to assets ratio tend to indicate lower borrowing capacity should the need arise for future financing.
As a creditor you would prefer a debt ratio that is much lower than the Equity Ratio. A low debt ratio, and a correspondingly high equity ratio tends to indicate greater security for creditors against any reduction in the value of a company’s assets.
Like all financial ratios, a company's debt ratio should be compared with their industry average. Several modern software tools available to ProAdvisors make such computations and comparisons relatively easy.
The Relationship between the Equity Ratio and Debt Ratio
Let’s recall that the Equity Ratio is Total Equity divided by Total Assets, and as we just learned the Debt Ratio is Total Debt divided by Total Assets. Because they both share the same divisor (Total Assets) the two ratios complement each other and always sum to a total of 1.0; so if you know the Equity Ratio you can instantly know the Debt Ratio, and vice versa.
Borrowing funds and leveraging the company is a routine part of growing a small business into something larger; however, it is essential for a company to continually monitor the relationship between debt, equity, assets and cash flow. ProAdvisors need to position themselves with the necessary knowledge and software tools to help small businesses compute and analyze these critical measures to insure the health of their company.
In situations in which a company becomes excessively leveraged, a strategy is essential to reduce the company’s debt. A detailed plan to improve revenues, reduce spending, eliminate excess inventory, refinance existing debt for better terms, and/or downsize. While it is always appropriate to have contingency plans to accomplish these steps, it is far better to have a sound financial management plan in place and continually monitor business analytics to make routine adjustments so as to avoid the necessity of enacting such a contingency plan.
Debt Coverage Ratios
Debt coverage ratios are datametrics which measure cash available for debt servicing of interest, principal and lease payments. It is a vital measurement of a company’s ability to produce enough cash to cover its debt (including lease) payments. From a future financing standpoint, the higher the ratio, the easier it is to obtain a loan. But Debt Coverage Ratios are also used in commercial banking to express a minimum ratio that is acceptable to a lender typically as a loan covenant. Breaching such a covenant can, in some circumstances, result in default.
When a small business gets a bank loan, the loan agreement may include a minimum debt coverage ratio and require financial statements be submitted showing that the specified ratio has been met on a monthly, quarterly, semi-annual or annual basis. The required ratio will vary from loan to loan and financial institution to financial institution. The ProAdvisor needs to be aware of the possible existence of such debt coverage requirements, and be able to assist businesses in computing the ratio in accordance with the provisions of the debt service covenants.
General Reference and Resource: Business Analysis for QuickBooks, Conrad Carlberg, Author, William “Bill” Murphy, Technical Editor; Wiley Publishing, 2009.