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  5. How to Assess the Ratio of Debt, Solvency and Liquidity of a Company

How to Assess the Ratio of Debt, Solvency and Liquidity of a Company

How to Assess the Ratio of Debt, Solvency and Liquidity of a Company

The percentage of external financing a company has concerning its assets is a mathematical ratio representing the total percentage of debt a business has in relation to its own resources.

The EAE Business School professor, Juan Carlos Higueras, describes it very well when comparing it to a prevalent situation that most people go through: when you buy a home through a mortgage, the debt ratio is the percentage of the value of the mortgaged home. And if the bank grants us a mortgage for 80% of its value, our indebtedness is 80%.

Therefore, the debt ratio determines the percentage of a company’s assets financed by debt. In this way, the external financing available to the company and its own resources is known, giving a clear overview of how the company is financed and its leverage.

It is for all these reasons that debt ratios allow us to analyze the financial structure of a company. We use these ratios to determine the amount of debt a company has and the relationship between that debt and other financial magnitudes (Assets, Profits, etc.). In this way, we can foresee financial risks and difficulties in paying interest and even assess whether a company has too high a debt level to invest in.

Differences between debt ratio, liquidity ratio and solvency ratio

It is convenient to know how to distinguish three concepts that sometimes tend to be confused:

  • The liquidity ratio is used to analyze a company’s potential to meet certain short-term financial obligations.
  • The debt ratio reflects the percentage of external financing of a company.
  • The solvency ratio is a company’s ability to meet its debts using its assets.

Next, we will focus on some of the principal debt ratios and their formulas and interpretation. None of them is better than another, nor is it necessary to take all of them into account. Still, they all provide information about the level of indebtedness of a company. Depending on the sector to which a company belongs, a value in one ratio or another may or may not be considered excessive, so the industry to which a company belongs must always be considered when analyzing debt ratios.

Debt ratio | Formula and interpretation

It measures the relationship between the capital contributed by creditors (debt = debt) and that contributed by shareholders (equity = equity). The debt ratio formula is as follows:

 Debt Ratio = Net Financial Debt / Net Equity

It is a quick tool that indicates the financial leverage used by a company; that is, it provides an idea of the extent to which it uses debt to finance its operations, and its interpretation is:

  • A ratio of 1.0 means that a company finances its projects with a balanced mix of debt and equity.
  • A high debt-to-equity ratio (>2.00) is concerning, as it could indicate dangerous amounts of leverage.
  • A small ratio (<0.3) may indicate that a conservative administration is unwilling to take risks.

Debt to Assets | Formula and interpretation

This ratio shows a company’s debt compared to its assets, allowing leverage comparisons to be made across different companies. The higher the ratio, the higher the degree of financial leverage and, therefore, the financial risk.

Debt to Assets = Net Financial Debt / Total Assets

It is a tool often used to measure a company’s capital structure.

Interest Coverage | Formula and interpretation

This ratio measures the company’s ability to generate sufficient resources to deal with the company’s debt. I leave you with the interest coverage formula:

Interest Coverage = Operating Income / Financial Expenses

The higher positive values we obtain from this ratio, the greater the company’s ability to meet the interest cost.

Solvency ratio | Formula and interpretation

Solvency measures a company’s ability to meet payment obligations. This indicator expresses that part of the debt is guaranteed with its own assets. However, more is needed to ensure that the creditor will collect at the indicated time since liquidity problems may arise.

Solvency Ratio Formula = Total Assets / Total Liabilities

And regarding the interpretation: A ratio well below 1.5 indicates that the company may not have the solvency to cover all its debt with its assets, so the closer it is to zero, the more at risk the company is.

On the other hand, a solvency ratio well above 1.5 means that the company has many more resources in cash and, therefore, is not as efficient as it could be. It has too many idle resources.

While a ratio of 1.5 (or close to it) is understood as the perfect balance, the company has enough assets to meet all its debt without having excessive idle resources.

Acid test | Formula and interpretation

The company needs a minimum level of inventory to be able to carry out its activity. To do this, we use the acidity ratio that indicates the immediate liquidity of a company; that is, it is an indicator that shows us the level of short-term liquidity that a company has.

Acid Ratio = (Current Assets – Inventories) / Current Liabilities

Thus, the interpretation of the acid test is as follows:

  • Less than 1: It would indicate an excessively high current liability in relation to the asset. It would be advisable to sell stocks to better deal with short-term debts, or you could face problems due to a lack of liquidity. In this case, it would not have passed the acid test.
  • Greater than 1: Indicates that the company has sufficient resources to meet its obligations in the short term. In this case, it would have passed the acid test. However, if the ratio were too greater than one, it would again indicate that it has idle resources:
  • Close to 1: It is again the ideal ratio, reaching a balance between debts covered with the company’s liquidity but without idle resources.

Current Ratio | Formula and interpretation

This ratio is used to see if the company can meet its debts in the short term. The formula to calculate the current ratio is as follows:

Current Ratio = Current Assets / Current Liabilities

The current ratio is interpreted as follows:

  • If the current ratio exceeds 1, the company has enough current assets to cover its short-term obligations. This may indicate that the company is solvent and in good financial standing.
  • If the current ratio is less than 1, the company may need help meeting its short-term obligations. This may indicate that the company is in a precarious financial situation.
  • If the current ratio equals 1, the company has the current assets necessary to cover its short-term obligations. This can indicate a stable financial situation, but not necessarily decisive.

Financial payment capacity

Measures the company’s ability to meet its financial debt based on its EBITDA generation (earnings before interest, taxes, depreciation and amortisation). It can be measured in terms of total and net financial debt.

Financial payment capacity = Net Financial Debt / EBITDA

  • It is a ratio that shows the financial health of the company. The lower the value of the balance, the fewer problems the company will have in paying the debt
  • If the ratio is less than 2, you are in a company with an excellent capacity to pay the debt.
  • If it is less than 4, the company may face some financial problems.

Conclusions about the debt ratio

Undoubtedly, the different debt ratios we have seen are essential to assess a company’s financial situation. However, our fundamental analysis should go further and include it here.

When evaluating a company’s solvency, it is essential to consider other ratios and indicators in addition to the debt ratio. One of the main reasons is that the debt ratio only provides a partial view of the company’s financial situation. For example, the debt ratio does not consider the company’s performance or its ability to generate revenue and profit in the future.

We should also measure other company valuation ratios, such as PER, EV/EBITDA or Free Cash Flow, without neglecting earnings per share.

Another reason it is essential to consider other ratios and indicators is that the debt ratio can give a distorted picture of a company’s solvency in certain situations. For example, if the company has a high amount of fixed assets, its debt ratio may be low even if it is having difficulties.

In summary, the debt ratio is an important measure to assess a company’s solvency, but it is not the only one. To obtain a complete evaluation of the company’s financial situation, it is essential to consider other ratios and indicators of income and performance.

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