Assessing Debt Capacity

Sir, there’s a new 5-year instrument issued by company Y with an attractive coupon; I think we should jump on it. 

Hmmm, thank you Mariam for sharing the opportunity; however, do they have the capacity to pay back?

That’s the big question most investors ask when considering investment options, can they pay my money back as at when due without plenty drama/stories.  

Today I will reflect on one of the key ratios learnt from the corporate financial accounting session; Investors look at this ratio before considering placing their funds with a company.

The Solvency Ratio:

Solvency ratio is a key metric used to measure a company’s ability to meet its long-term debt obligations and is often used by prospective business lenders. A solvency ratio indicates whether a company’s cash flow is sufficient to meet its long-term liabilities and thus is a measure of its financial health. An unfavorable ratio can indicate some likelihood that a company will default on its debt obligations.

Key learnings:

• A solvency ratio examines a company’s ability to meet its long-term debts and obligations.
• The solvency ratios include the debt-to-assets ratio, the interest coverage ratio, the equity ratio, and the debt-to-equity (D/E) ratio.
• Prospective lenders often use Solvency ratios i.e., Investors and financial institutions, when evaluating a company’s creditworthiness as well as by potential bond investors.
• Solvency and liquidity ratios measure a company’s financial health, but solvency ratios have a longer-term outlook than liquidity ratios.

Basic Understanding of solvency ratio.

A solvency ratio is one of many metrics used to determine whether a company can stay solvent in the long term. A solvency ratio is a comprehensive measure of solvency. It measures a firm’s actual cash flow, rather than net revenue, by adding back depreciation and other non-cash expenses to assess a company’s capacity to stay afloat in business.

It measures this cash flow capacity versus all liabilities rather than only obligations. This way, a solvency ratio assesses a company’s long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.

Solvency ratios vary from industry to industry. Therefore, a company’s solvency ratio should be compared with its competitors in the same industry rather than viewed in isolation.

The main solvency ratios are:

• The debt-to-assets ratio.
• The interest coverage ratio.
• The equity ratio.
• The debt-to-equity (D/E) ratio. 

Types of solvency ratios

• Interest Coverage Ratio: The interest coverage ratio measures how often a company can cover its current interest payments with its available earnings. In other words, it measures the margin of safety a company has for paying interest on its debt during a given period. The higher the ratio, the better. If the ratio falls to 1.5 or below, it may indicate that a company will have difficulty meeting the interest on its debts.
• Debt to assets ratio: The debt-to-assets ratio measures a company’s total debt to its total assets. It measures a company’s leverage and indicates how much of the company is funded by debt versus assets and therefore, its ability to pay off its debt with its available assets. A higher ratio, especially above 1.0, indicates that a company is significantly funded by debt and may have difficulty meetings its obligations.

• Equity Ratio: The equity ratio, or equity-to-assets, shows how much of a company is funded by equity as opposed to debt. The higher the number, the healthier a company is. The lower the number, the more debt a company has on its books relative to equity.

In my next episode, I will share more insight into another type of ratio used in measuring a company’s capacity to pay its short-term obligations- The “Liquidity Ratio”

#MEMBA11#

Reference:

1. Financial Statement Analysis Note.
2. https://www.investopedia.com/