Objectives

• Define solvency (2.A.2.d).

• Calculate and interpret the following ratios: debt-to-equity, long-term debt-to-equity, and debt-to-total assets (2.A.2.i). 

• Define, calculate, and interpret the following ratios: fixed charge coverage (earnings to fixed charges), interest coverage (times interest earned), and cash flow to fixed charges (2.A.2.j).

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Solvency

• the ability of a company to survive over a long period of time. 

• the capacity of the business to settle both its long-term and current liabilities as they become due.

• Uses components from the balance sheet, income statement, and the statement of cash flows.

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Solvency Ratio

• Measure a company's ability to meet its long-term financial commitments. 

• Checking if you have enough savings to cover your long-term debts. 

• A higher ratio means more financial stability, while a lower one could signal potential risk

• Assesses a company's long-term health by evaluating its repayment ability for its long-term debt and the interest on that debt.

• May vary from industry to industry.

• A company’s solvency ratio should be compared with its competitors in the same industry rather than viewed in isolation.

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Types of Solvency Ratio

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1. Debt-to-Equity Ratio

• Measures the relationship between total liabilities and stockholders’ equity

• Proportion of debt financing relative to equity financing used by a company. 

• A high ratio may indicate higher financial risk, as it suggests that the company relies more on debt to finance its operations. 

• A low ratio may indicate a more conservative financial approach.

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2. Long-term Debt-to-Equity

• Measures the relationship between only the long-term liabilities and stockholders’ equity. This excludes the current liability of the company to further measure its capacity to repay debts.

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3. Debt-to-Assets Ratio

• This ratio indicates the percentage of a company's assets that are funded by debt, rather than equity. 

• Lower ratio indicates that the company relies less on debt financing

• T​​he higher the ratio, the more debt a company has on its books, meaning the likelihood of default is higher. 

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4. Fixed Charge Coverage Ratio

• A.k.a Earnings before Fixed Charges and Taxes

• Measure how well earnings can cover fixed charges. 

• The earnings amount used is earnings before fixed charges and taxes. 

• Fixed charges include interest, required principal repayment of loans, and leases.

• A low ratio often reveals a lack of ability to make payments on fixed charges, a scenario lenders try to avoid since it increases the risk that they will not be paid back.

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5. Interest Coverage Ratio

• a.k.a Times Interest Earned Ratio

• Measure how well earnings can cover interest expense.

• A higher coverage ratio is better for the solvency of the business while a lower coverage ratio indicates debt burden on the business.

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LIMITATIONS OF SOLVENCY RATIOS

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A company might possess minimal debt, yet if its handling of cash is subpar and its outstanding payments are escalating, its financial stability might not be as robust as suggested solely by debt-related metrics. It's crucial to examine diverse ratios to grasp a company's genuine financial well-being and to comprehend the factors influencing these ratios. Additionally, mere numerical values such as percentages are insufficient for assessment; a company should be evaluated against its industry counterparts, particularly those demonstrating strength, to gauge the acceptability of its ratios. It is also better to use actual amounts for comparison purposes than percentages.

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SUMMARY

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Solvency ratios evaluate an organization's stability over time.  This indicates that it will continue to operate for a sufficient amount of time to pay off all debt, both short- and long-term. It's critical to retain the formulas in order to complete the computations, understand the outcomes, and evaluate the solvency of an entity.

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PRACTICE QUESTIONS

1. In which scenario would a horizontal analysis be the best choice? (3)

A. A bank wishes to compare progress among different companies.

B. A company wishes to market its growth to potential stockholders.

C. A vendor wishes to evaluate financial statement data in a given year.

D. An investor wishes to evaluate financial statement data by expressing each item in a financial statement as a percentage of a base amount.

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2. A company can improve its debt-to-total assets ratio by doing which of the following?

A. Borrow more.

B. Shift short-term to long-term debt.

C. Shift long-term to short-term debt.

D. Sell common stock.

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3. Which ratio would a bondholder most closely analyze?

A. Current ratio

B. Solvency

C. Accounts receivable turnover

D. Fixed asset ratios

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4. Which answer explains the analysis of the debt ratio?

A. A low ratio shows the company is highly leveraged.

B. The ratio cannot be analyzed unless compared to a competitor or industry average.

C. The higher the ratio, the more favorable.

D. The higher the ratio, the more unfavorable.

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5. Which of the following will help decrease a company's total debt-to-equity ratio, if all else is equal?

A. Buying Treasury stock

B. Lowering the dividend payout ratio

C. Paying cash dividends to stockholders

D. Converting long-term debt to short-term debt

 

6. An investor is investigating the solvency of four companies. Based on their solvency, which company is the investor most likely to invest in?

A. A company with total assets of $137 million and total liabilities of $65 million

B. A company with total assets of $462 million and total liabilities of $159 million

C. A company with total assets of $53 million and total liabilities of $18 million

D. A company with total assets of $714 million and total liabilities of $594 million

 

7. Which of the following companies will most likely be unable to pay their interest expenses?

A. Latimer Industries has net income of $346,000, income tax of $186,000, and interest expense of $321,000.

B. Thorn Enterprises has net income of $618,000, income tax of $333,000, and interest expense of $468,000.

C. Easton Restaurants has net income of $942,000, income tax of $507,000, and interest expense of $694,000.

D. Wicker Baskets has net income of $437,000, income tax of $235,000, and interest expense of $192,000.

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8. Seventeen Industries has a debt-to-equity ratio of 1.6 compared with the industry average of 1.4. This means that the company:

A. will not experience any difficulty with its creditors.

B. has less liquidity than other firms in the industry.

C. will be viewed as having high creditworthiness.

D. has greater than average financial risk when compared to other firms in its industry.

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9. The following data pertain to Vernon Corp.’s operations for the year ended December 31, Year 1: (4)

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The times interest earned ratio is:

A. 8.0 to 1. 

B. 7.0 to 1. 

C. 2.1 to 1. 

D. 4.9 to 1. 

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10. A company's income statement shows interest expense of $5 million, sales revenue of $50 million, earnings before interest and taxes of $20 million, and net income of 58 million. This company has a times interest earned (or interest coverage) ratio of

A. 10.

B. 4.

C. 1.6.

D. 0.25.

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ANSWER KEY

1. B

2. D

3. B

4. B

5. D

6. C

7. A

8. D

9. A

10. B.

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REFERENCES:

Hayes, A. (2023, December 20). What Is a Solvency Ratio, and How Is It Calculated? Investopedia. https://www.investopedia.com/terms/s/solvencyratio.asp#toc-understanding-solvency-ratios 

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Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set. Wiley.

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