Last October, this newsletter addressed liquidity ratios, financial metrics that monitor the likelihood of running out of cash and the inability to pay bills when due.
You might think of liquidity ratios as providing early warning signs of an impending car crash while driving.
Today we address solvency ratios. These measure a company's ability to fulfill its long-term debt obligations.
Sticking with our transportation metaphor, solvency ratios are used to spot slow moving train wrecks, often well in advance. Lenders use these to judge the risk that a loan can't be repaid (short of selling or liquidating the company). There are there are three types of solvency ratios:
- The solvency ratio looks at the income statement in conjunction with the balance sheet.
- Debt ratios look at the balance sheet alone and weigh the amount of debt versus equity.
- Coverage ratios look at the income statement and are a measure of a company's ability to make debt payments.
Let's take a closer look at each... The Solvency Ratio
The solvency ratio is net income plus depreciation and amortization, divided by total liabilities. It is a ratio of accounting cash flow to total liabilities. Or
(NI + D + A)/TL,
Where NI is Net Income after taxes,
D is Depreciation expense,
A is Amortization expense,
And TL is total average liabilities for the period of the income statement measures in the numerator of this ratio. Higher solvency ratios are better (less risky).Debt Ratios
For all of following debt ratios, the lower the number the better (i.e., the less risk of default). The first ratio is Debt to Total Assets,
Where TD is total debt or is all interest-bearing short and long term debt,
And TA is total assets on the balance sheet.
This measure looks at total assets that could be liquidated in some form to pay all of the debt. The second ratio is the debt to capital ratio
or TD/(TD + SE), where SE is Shareholder's Equity. This ratio looks at how much of the capital that finances a company is debt. The more debt relative to equity the more risk, as debt must be paid interest but dividend payments to shareholders are discretionary. The third debt ratio is the debt to equity ratio
or TD/SE. For public companies large enough for the debt to be publicly traded bonds, this measure can be quoted with market prices instead of accounting numbers. The final debt ratio is leverage or total assets divided by total equity
(TA/SE). Used as a measure of insolvency instead of as a component of the DuPont Formula
, it shows how many dollars of assets are supported by each dollar of equity. Coverage Ratios
For coverage ratios, the higher
the number the better (less risky). The first coverage ratio is the interest coverage ratio
Where EBIT is earnings before interest and taxes (but after depreciation and amortization) and IP is total interest payments for the time period, typically interest expense from the income statement. So, the higher the number the more income is available to pay interest. Note that interest expense in the income statement may include imputed interest in leases and interest that is not paid with cash in payment in kind loans. The fixed charge coverage ratio
is (EBIT + LP)/(LP + IP), where LP is Total Lease Payments, so total debt interest expense plus total lease payments. This ratio is often used as a covenant in loans to small and medium sized businesses. This ratio gets to the ability to make these fixed charges including loan payments. Comparative Examples
Now let's consider some examples which employ these ratios:
Above are the ratios for four, very different, large public companies.
|IBM||Wells Fargo||International Paper||General Motors|
|FY 2013||FY 2013||FY 2013||FY 2008|
|Fixed Charge Ratio||11.4||N/A||2.0||(6.1)|
IBM is known for stable and predictable earnings and cash flow. Wells Fargo is recognized as a well run Bank. International Paper is a cyclical, capital-intensive manufacturer. Lastly, we all know General Motors, the company that kept saying in early 2009 they would not file for bankruptcy. (Sadly, GM's management didn't lie, they were just oblivious to reality.) Some observations...
- The highest solvency ratio is for IBM with its predictable cash flow, followed by International Paper. Wells Fargo is almost zero because the denominator in this ratio is average total liabilities that includes just over $1 Trillion in deposits which are liabilities but not part of total debt.
- For IBM and IP, the Debt to Total Assets and Debt to Total Capital Ratios are not that different, but IBM is clearly less risky as its solvency ratio is much higher. Debt to Equity and Leverage are noticeably higher than for IP as IP has lower margins to support interest payments and is much more cyclical.
- Look how different Wells Fargo is from IBM and IP. Debt to total assets is low because all of those bank assets are funded primarily with deposits that, while a current liability, are not considered debt. Debt to total capital is not that different from IBM or IP, but the leverage ratio tells the story at 90.2. For every dollar in equity, Wells Fargo has 90.2 dollars in assets, whereas IBM only has 5.4 dollars and capital intensive IP has 3.7.
- The much lower interest coverage ratio and Fixed Charge Coverage Ratio for IP compared to IBM reflects the much lower margins in IP's business. No interest coverage or fixed charge ratio is shown for Wells Fargo, because most of its interest expense is best considered part of cost of goods sold. In fact, banks, on their income statement, show net interest revenue (net of interest expense) instead of gross profit.
These ratios can be used in a number of helpful ways:
- The numbers for General Motors are flashing bright red across the board except the debt to capital ratio which is a mere yellow. Yet, GM's management believed right up until the very end that the Company wouldn't file for bankruptcy.
- Track them for your business over time and calculate them when plans, budgets or projections are done. Obviously, improving ratios are better than the alternative (remember that seasonal patterns may have an impact). When these ratios get or are projected to get out of line with industry standards, changes to the company's capital structure are likely needed.
- Creditors use these ratios to evaluate debtors. You can use them too to track your customers where appropriate and to see how creditors, particularly banks, view you.
Some important caveats:
- Use them to compare your business with competitors. Use published financials for public companies. For private companies, industry-specific ratios are often available from various service providers.
- Always use judgment. Ratios should not be used alone to assess liquidity nor should one liquidity ratio be used in isolation of other ratios.
- Always consider differences. When using ratios to compare companies, consider differences in accounting methods (e.g. , LIFO vs FIFO for inventory) and the comparative homogeneity of operating units. Using ratios to compare a company that operates in just one business with one that operates in several is often of limited value.
Remember, solvency ratios spot slow moving train wrecks.
- Sometimes, slightly different definitions of these ratios are used. When using ratios provided by others, check their formula. Loan covenants may have ratios with the same names as these, but slightly different definitions. Always read the loan agreement and calculate loan covenants as specified in the documents. I have seen numerous iterations on the fixed charge coverage ratio, for example.
And while these problems may take time to materialize, like a real train wreck, the results can be devastating. Keep an eye on yours!