Investing Basics: Understanding and Evaluating Solvency
When learning about the basics of investing, solvency, just like liquidity, is another core concept that is essential to know about.
When it comes to analysing stocks, firm solvency is what we’re most interested in. But what is it?
Solvency represents the ability of a company to meet all of its obligations, both short-term and long-term. By comparison, liquidity only looks at short-term assets and liabilities.
Investing Basics: Evaluating Solvency
The most common ratio used to investigate solvency is Debt-To-Equity.
It simply compares the total number of liabilities to the total shareholder’s equity. A value greater than 1.0 means there is more Debt on the Balance Sheet than Equity, and vice versa. Generally, a higher level of debt means more leverage, which means more risk.
But, the Debt-To-Equity ratio is not particularly intuitive. And so we much prefer the Debt-To-Capital ratio instead.
This ratio provides the same insight as to the Debt-To-Equity ratio. However, it calculates the total percentage of debt within the firm’s capital structure. This makes the balance between debt and equity more clear.
Both ratios ultimately tell you the same thing, so choosing which one to use is a personal decision.
In both cases, the result should be compared against industry averages or collection of competitors, to see whether the level of debt is higher (more risk) or lower (less risk) by comparison.
Going even deeper
Calculating either of these ratios and comparing them against averages will give a quick and meaningful insight into a company’s financial health.
However, every business is fundamentally different in some shape or form. Therefore, it’s entirely possible to find companies with higher levels of debt in better financial condition than those with low levels of debt.
The question then becomes, how do you know whether a firm’s debt level is too high?
Enter the Interest Coverage Ratio.
This metric reveals how many times a company can pay the interest on its debt. A value of less than 1.0 means that interest payments are higher than the business’s underlying profit. This indicates the company cannot keep up with interest payments on its existing debt and will have to find a way to raise additional capital to remain afloat.
Generally, a value of 3.0 or more indicates robust solvency and therefore, better financial health – even if there is a lot of debt on the balance sheet.
But debt interest isn’t the only recurring long term expense a business needs to worry about. Adding leases on properties such as offices, warehouses, or factories, into the equation provides a better insight into the firm’s ability to meet all of its obligations.
The interpretation remains the same, but this modified version is far more accurate.
Going beyond the basics of investing
Another interesting question to ask is whether a firm doesn’t have enough debt?
For example, suppose a stock has an Interest Lease Coverage Ratio of 15. In that case, it would mean the company could easily take on significantly more debt at relatively low-interest rates. This additional funding can be used to fuel growth, so why not take advantage of the business’s strong financial health to raise cheap capital?
Calculating a firm’s Optimum Capital Structure is a complex process that goes beyond the basics of investing. But it will be covered in a future article. But if you’re interested in finding out more, the Corporate Finance Institute has some good explanations.
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