Friday, May 22, 2009

Financial Ratios, pt 3 - Solvency Ratios

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]

Solvency ratios are similar to liquidity ratios except that they focus on the long term ability of the firm to meet it's debt obligations. As a result, by looking at solvency ratios, you can determine leverage, coverage, etc.

Because solvency looks at the broadest measures of financial position, the terms which most often appear in solvency ratios are the bottom lines of balance sheets (Assets, Debt and Equity). Recall the fundamental accounting principle that

Assets = Liabilities + Equity

Basic Solvency Ratios:
Debt-to-Assets = Debt / Assets
Debt-to-Equity = Debt / Equity

Financial Leverage of Assets (FLA):
Financial Leverage = Assets / Equity

A critical part of DuPont Analysis, Financial Leverage also identifies the overall riskiness of the company (higher leverage = higher risk) and directly affects return on equity (ROE). Financial leverage is the cornerstone of financial investing and can turn a "good deal into a great deal".

Note that FLA can be determined from D/E.
= ((D+E) / E)
= E/E + D/E
= 1 + D/E

Interest Coverage:
Interest Coverage = EBIT / Interest Payments

Interest Coverage describes your ability to make interest payments. If this is less than 1 this is a *DISASTER*. It means that not only do you have enough money to make your interest payments, but you can't even begin to consider paying down your principle let alone think about profits. This also implies that your principle will grow (interest not immediately paid off becomes part of the new principle amount). I would expect any company with an interest coverage ratio of less than one is quickly and unceremoniously headed for bankruptcy.

By that very token, I would suggest that this ratio isn't actually very useful except to tell you how much trouble you are in (at a time when it's too late BTW). Since the numerator is EBIT (which is directly related to net income and retained earnings), you generally want this number as sustainably high as possible) so unlike some of the previous ratios, there is very little downside to having exorbitantly high interest coverage ratios.

Fixed Charge Coverage
Fixed Charge Coverage = [EBIT + lease payments] / [Interest + lease payments]

Similar to the idea of the interest coverage ratio, the fixed charge ratio takes into account lease payments. It is a little more all encompassing in that it also considers lease payments (not considered discretionary).

[ Financial Ratios, Part: 1 - 2 - 3 - 4 ]