Solvency Flashcards
What does solvency mean?
Solvency is a firm’s ability to pay its noncurrent obligations as they come due and thus remain in business in the long run (contrast with liquidity)
The key ingredients of solvency are the firm’s capital structure and degree of financial leverage
What is a firm’s capital structure?
A firm’s capital structure includes in sources of financing, both long and short term
These sources can be in the form of debt (external sources) or equity (internal sources)
Capital structure decisions affect the risk profile of a firm. For example, a company with a higher % of capital will be risker than a firm with a high % of equity capital
Thus, where there is a lot of debt, equity investors will demand a higher rate of return on their investments to compensate for the risk bought about by the high use of financial leverage
Alternatively, a company with a high level of equity capital will be able to borrow at lower rates because debt holders will accept lower interest in exchange for the lower risk indicated by the equity cushion
What are characteristics of Debt pertaining to a firm’s capital structure?
Debt is the creditor interest in the firm
The firm is contractually obligated to repay debt-holders. The terms of repayment (i.e. timing of interest and principal) are specified in the debt agreement
As long as the return on debt capital > amount of interest paid - the use of debt financing is advantageous to a firm. This is due to the fact that interest payments on debt are tax-deductible
The tradeoff is that an increased debt load makes a firm risker (since debt must be paid regardless of whether the company is profitable). At some point, either a firm will have to pay a higher interest rate than its return on debt or creditors will simply refuse to lend any more money
What are characteristics of Equity pertaining to a firm’s capital structure?
Equity is the ownership interest in the firm
Equity is the permanent capital structure of an enterprise, contributed by the firm’s owners in hopes of earning a return
A return of equity is uncertain because equity embodies only a residual interest in the firm’s assets (residual because it is the claim left over after all debt has been satisfied)
Periodic returns to owners of excess earnings are referred to as dividends. The firm may be contractually obligated to pay dividends to preferred stockholders, but not to common stockholders
What is Total Debt to Total Capital ratio?
The total debt to total capital ratio measures the % of the firm’s capital structure provided by creditors:
= Total debt / Total capital
When total debt to total capital is low, it means more of the firm’s capital is supplied by the stockholders. Thus, creditors prefer this ratio to be low as a cushion against losses
What is Debt to Equity ratio?
The debt to equity ratio is a direct comparison of the firm’s debt load versus its equity stake:
= Total debt / Stockholders’ equity
The debt to equity ratio reflects long-term debt-payment ability. A low ratio means a lower relative debt burden and thus better chances of repayment to creditors
What is Long-term Debt to Equity ratio?
The long-term debt to equity ratio reports the long-term debt burden carried by a company per dollar of equity:
= Long-term debt / Stockholders’ equity
A low ratio means a firm will have an easier time raising new debt (since its low current debt load makes it a good credit risk)
What is Debt to Total Assets ratio?
The debt to total assets ratio (also called debt ratio) reports the total debt burden carried by a company per dollar of assets:
= Total liabilities / Total assets
Numerically, this ratio is identical to the debt to total capital ratio
What are capital structure ratios?
Capital structure ratios report the relative proportions of debt and equity in a firm’s capital structure at a given reporting date
What are earnings coverage ratios?
Earnings coverage ratios are a creditor’s best measure of a firm’s ongoing ability to generate the earnings that will allow it to service debt out of current earnings
What is the Times Interest Earned Ratio?
The times interest earned ratio is an income statement approach to evaluating a firm’s ongoing ability to meet the interest payments on its debt obligations:
= EBIT / Interest expense
For the ratio to be meaningful, NI cannot be used in the numerator. Since what is being measured is the ability to pay interest, EBIT is appropriate
The most accurate calculation of the numerator includes ONLY earnings expected to recur. Consequently, unusual or infrequent items, extraordinary items, discontinued operations and the effects of accounting changes should be excluded
The denominator SHOULD include capitalized interest
What is Earnings to Fixed Charges Ratio?
The earnings to fixed charges ratio (also called the fixed charge coverage ratio) extends the times interest earned ratio to include the interest portion associated with long-term lease obligations:
= EBIT + Interest portion of operating leases /
(Interest expense + Interest portion of operating leases + Dividends on preferred stock)
Note: This is a more conservative ratio since it measures the coverage of earnings over all fixed charges, NOT just interest expense
What is Cash Flow to Fixed Charges Ratio?
The cash flow to fixed charges ratio removes the difficulties of comparing amounts prepared on an accrual basis:
= Pre-tax operating cash flow /
(Interest expense + Interest portion of operating leases + Dividends on preferred stock)
