Solvency
(A) BASICS OF SOLVENCY
Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. All business activities of a company namely; financing, investing, and operating affect a company’s solvency. Analysis of solvency involves several key elements where analysis of capital structure is one of these. Capital structure refers to the sources of financing for a company. Financing can range from relatively permanent equity capital to riskier or temporary short-term financing sources.
Once a company obtains financing, it subsequently invests it in various assets. Assets represent secondary sources of security for lenders and range from loans secured by specific assets to assets available as general security for unsecured creditors. These and other factors yield different risks associated with different assets and financing sources.
Another key element of long-term solvency is earnings implying the recurring ability to generate cash from operations. Earnings-based measures are important and reliable indicators of financial strength. Earnings are the most desirable and reliable source of cash for long-term payment of interest and debt principal
Lenders guard themselves against company insolvency and financial distress by including loan covenants in the lending agreements. Loan covenants set conditions of default, often based on accounting measures, at a level to allow the lender the opportunity to collect on the loan before severe financial distress. Covenants are often designed to:
I. Emphasize key measures of financial strength like the current ratio and debt to equity ratio
II. Prohibit the issuance of additional debt
III. Ensure against disbursement of company resources through excessive dividends or acquisitions.
Note: Covenants cannot assure lenders against operating losses neither can they substitute for our alertness and monitoring of a company’s results of operations and financial condition.
Importance of Capital Structure
Capital structure is the equity and debt financing of a company. It is often measured in terms of the relative magnitude of the various financing sources. A company’s financial stability and risk of insolvency depend on its financing sources and the types and amounts of various assets it owns.
Characteristics of Debt and Equity
Equity refers to the risk capital of a company. It contributes to a company’s stability and solvency. Characteristics of equity capital include:
i. Its return is uncertain or unspecified – There is no mandatory dividend requirement
ii. It lacks any repayment pattern – It is characterized by a degree of permanence and persistence in times of adversity
Unlike equity capital, both short-term and long-term debt capital must be repaid. The longer the debt repayment period and the less demanding its repayment provisions, the easier it is for a company to service debt capital. Still, debt must be repaid at specified times regardless of a company’s financial condition, and so too must periodic interest on most debt. Failure to pay principal and interest typically results in legal proceedings where common shareholders can lose control of the company and all or part of their investment.
For investors in common stock, debt reflects a risk of loss of the investment, balanced by the potential of profits from financial leverage. Financial leverage is the use of debt to increase earnings. Leverage magnifies both managerial success (income) and failure (losses). Excessive debt limits management’s initiative and flexibility for pursuing profitable opportunities.
For creditors, increased equity capital is preferred as protection against losses from adversities. Lowering equity capital as a proportionate share of a company’s financing decreases creditors’ protection against loss and consequently increases credit risk. Our analysis task is to measure the degree of risk resulting from a company’s capital structure. The remainder of this section looks at the motivation for debt capital and measuring its effects.
Motivation for Debt Capital
From a shareholder’s perspective, debt is a preferred external financing source for at least two reasons:
i. Interest on most debt is fixed and, provided interest cost is less than the return on net operating assets, the excess return is to the benefit of equity investors.
ii. Interest is a tax-deductible expense, whereas dividends are not.
Concept of Financial Leverage
Companies typically carry both debt and equity financing. Creditors are generally unwilling to provide financing without protection provided by equity financing. Financial leverage refers to the amount of debt financing in a company’s capital structure. Companies with financial leverage are said to be trading on the equity. This indicates a company is using equity capital as a borrowing base in a desire to reap excess returns. The illustration below illustrates trading on the equity. It computes the returns achieved for two companies referred to as Risky Inc. and Safety Inc.
Trading on the Equity—Returns for Different Earnings Levels ($ millions)
Assets
Financing Sources
Operating income before taxes
10% Debt Interest
Taxes (40%)
Net Income
NOPAT (Operating income x (1-40%))
Return on
Debt
Equity
Net operating Assets (RNOA)
Equity (ROE)
Year 1
Risky, Inc.
1000
400
600
200
40
64
96
120
12
16
Safety Inc.
1000
0
1000
200
0
80
120
120
12
12
Year 2
Risky, Inc.
1000
400
600
100
40
24
36
60
6
6
Safety Inc.
1000
0
1000
100
0
40
60
60
6
6
Year 3
Risky, Inc.
1000
400
600
50
40
4
6
30
3
1
Safety Inc.
1000
0
1000
50
0
20
30
30
3
3
Return on net operating assets = NOPAT / Net Operating Assets.
Return on equity = Net income / Shareholders’ equity
These two companies have identical net operating assets and operating income. Risky, Inc., derives 40% of its financing from debt, while Safety, Inc., is debt-free, or unlevered. For Year 1, when the average return on net operating assets is 12%, the return on stockholders’ equity of Risky, Inc., is 16%. This higher return to stockholders is due to the excess return on net operating assets over the after-tax cost of debt (12% versus 6%, the latter computed as 10% [1 - 0.40]). Safety, Inc.’s return on equity always equals the return on assets since there is no debt. For Year 2, the return on assets of Risky, Inc., equals the after-tax cost of debt and, consequently, the effects of leverage are neutralized. For Year 3, leverage is shown to be a double-edged sword. Specifically, when the return on net operating assets is less than the after-tax cost of debt, Risky, Inc.’s return on equity is lower than the return on equity for debt-free Safety, Inc. To generalize from this example:
i. A levered company is successfully trading on the equity when return on assets exceeds the after-tax cost of debt
ii. A levered company is unsuccessfully trading on the equity when return on net operating assets is less than the after-tax cost of debt, and
iii. Effects of leveraging are magnified in both good and bad years.
Tax Deductibility of Interest
One reason for the advantageous position of debt is the tax deductibility of interest. We illustrate this tax advantage by extending the case in illustration I above. Let us reexamine the two companies’ results ($ millions) for Year 2:
Year 2
Risky, Inc.
Safety, Inc.
Income before interest and taxes
$100
$100
Interest (10% of $400)
(40)
0
Income before taxes
60
100
Taxes (40%)
(24)
(40)
Net income
36
60
Add back interest paid to bondholder
40
0
Total return to security holders (debt and equity)
$ 76
$ 60
Recall the leverage effects are neutral in Year2. Still notice that even when there turn on net operating assets equals the after-tax cost of debt, the total amount available for distribution to debt and equity holders of Risky, Inc., is $16 higher than the amount available for the equity holders of Safety, Inc. This is due to the lower tax liability for Risky, Inc. We must remember the value of tax deductibility of interest depends on having sufficient income.
To generalize from this example:
i. Interest is tax deductible, whereas cash dividends to equity holders are not
ii. Because interest is tax deductible, the income available to security holders can be much larger, and
iii. Nonpayment of interest can yield bankruptcy, whereas nonpayment of dividends does not.
Other Effects of Leverage
Beyond the advantages from excess return to financial leverage and the tax deductibility of interest, a long-term debt position can yield other benefits to equity holders. For example, a growth company can avoid earnings per share dilution through issuance of debt. In addition, if interest rates are increasing, a leveraged company paying a fixed lower interest rate is more profitable than its non-leveraged competitor. However, the reverse is also true. Finally, in times of inflation, monetary liabilities (like most debt capital) yield price-level gains.
Adjustments for Capital Structure Analysis
Measurement and disclosure of liability (debt) and equity accounts in financial statements are governed by the application of accepted accounting principles.
ADJUSTMENTS TO BOOK VALUES OF LIABILITIES
The relation between liabilities and equity capital, the two major sources of a company’s financing, is an important factor in assessing long-term solvency. An understanding of this relation is therefore essential in our analysis. There exist liabilities not fully reflected in balance sheets, and there are financing-related items whose accounting classification as debt or equity must not be blindly accepted in our analysis. Our identification and classification of these items depend on a thorough understanding of their economic substance and the conditions to which they are subject as discussed below:
Deferred Income Taxes. An important question is whether we treat deferred taxes as a liability, as equity, or as part debt and part equity. Our answer depends on the nature of the deferral, past experience of the account (such as its growth pattern), and the likelihood of future reversals. In reaching our decision, we must recognize that, under normal circumstances, deferred taxes reverse and become payable when a company’s size declines. To the extent future reversals are a remote possibility, as conceivable with timing differences from accelerated depreciation, deferred taxes should be viewed like long-term financing and treated like equity. However, if the likelihood of a drawing down of deferred taxes in the foreseeable future is high, then deferred taxes (or part of them) should be treated like long-term liabilities.
Operating Leases. Current accounting practice requires that most financing long-term no cancelable leases be shown as debt. Yet companies have certain opportunities to structure leases in ways to avoid reporting them as debt. Operating leases should be recognized on the balance sheet for analytical purposes, increasing both fixed assets and liabilities.
Off-Balance-Sheet Financing. In determining the debt for a company, our analysis must be aware that some managers attempt to understate debt, often with new and sometimes complex means. Our critical reading of notes and management comments, along with inquiries to management, can often shed light on the existence of unrecorded liabilities.
Contingent Liabilities. Contingencies such as product guarantees and warranties represent obligations to offer future services or goods that are classified as liabilities. Typically, reserves created by charges to income are also considered liabilities. Our analysis must make a judgment regarding the likelihood of commitments or contingencies becoming actual liabilities and then treat these items accordingly. For example, guarantees of indebtedness of subsidiaries or others that are likely to become liabilities should be treated as liabilities.
Minority Interests. Minority interests in consolidated financial statements represent the book value of ownership interests of minority shareholders of subsidiaries in the consolidated group. These are not liabilities similar to debt, because they have neither mandatory dividend payment nor principal repayment requirements. Capital structure measurements concentrate on the mandatory payment aspects of liabilities. From this point of view, minority interests are more like outsiders’ claims to a portion of equity or an offset representing their proportionate ownership of assets.
Convertible Debt. Convertible debt is usually reported among liabilities (or as an item separate from both debt and equity listings). If conversion terms imply this debt will be converted into common stock, then it can be classified as equity for purposes of capital structure analysis.
Preferred Stock. Most preferred stock requires no obligation for payment of dividends or repayment of principal. These characteristics are similar to those of equity. However, preferred stock with mandatory redemption requirements is similar to debt and should be considered as debt in our analysis.
(B) CAPITAL STRUCTURE COMPOSITION AND SOLVENCY
The fundamental risk with a leveraged capital structure is the risk of inadequate cash under conditions of adversity. Debt involves a commitment to pay fixed charges in the form of interest and principal repayments. While certain fixed charges can be postponed in times of cash shortages, the fixed charges related to debt cannot be postponed without adverse repercussions to a company’s shareholders and creditors.
Measures commonly used to estimate the degree of financial leverage and to evaluate the risk of insolvency.
a) Capital Structure Measures for Solvency Analysis
b) Asset-Based Measures of Solvency
(a) Capital Structure Measures for Solvency Analysis
(1.) Common-Size Statements in Solvency Analysis
A common measure of financial risk for a company is its capital structure composition. Composition analysis is performed by constructing a common-size statement of the liabilities and equity section of the balance sheet. An advantage of a common size analysis of capital structure is in revealing the relative magnitude of financing sources for a company. Common-size analysis also lends itself to direct comparisons across different companies. A variation of common-size analysis is to perform the analysis using ratios. Another variation focuses only on long-term financing sources, excluding current liabilities.
(2.) Capital structure ratios are another means of solvency analysis.
Ratio measures of capital structure relate components of capital structure to each other or their total. In this section we describe the most common of these ratios. We must take care to understand the meaning and computation of any measure or ratio before applying it.
Capital structure ratios:
I. Total Debt to Total Capital
A comprehensive ratio is available to measure the relation between total debt and total capital. The total debt to total capital ratio (also called total debt ratio) is expressed as: Total debt /Total capital
This measure is often expressed in ratio form.
II. Total Debt to Equity Capital
Another measure of the relation of debt to capital sources is the ratio of total debt to equity capital. The total debt to equity capital ratio is computed as: Total debt/Shareholders equity
III. Long-Term Debt to Equity Capital
The long-term debt to equity capital ratio measures the relation of long-term debt to equity capital. A ratio in excess of 1:1 indicates greater long-term debt financing compared to equity capital. This ratio is commonly referred to as the debt to equity ratio and is computed as: Long-term debt/ Shareholders’ equity
IV. Short-Term Debt to Total Debt
The ratio of debt maturing in the short-term relative to total debt is an important indicator of the short-run cash and financing needs of a company. Short-term debt, as opposed to long-term debt or sinking fund requirements, is an indicator of enterprise reliance on short-term (primarily bank) financing. Short-term debt is usually subject to frequent changes in interest rates. Computed as: Short term debt/Total debt
Interpretation of Capital Structure Measures
Common-size and ratio analyses of capital structure are primarily measures of the risk of a company’s capital structure. The higher the proportion of debt, the larger the fixed charges of interest and debt repayment, and the greater the likelihood of insolvency during periods of earnings decline or hardship.
Capital structure measures serve as screening devices. For example, when the ratio of debt to equity capital is relatively small (10% or less), there is no apparent concern with this aspect of a company’s financial condition—our analysis is probably better directed elsewhere. Should our analysis reveal debt is a significant part of capitalization, then further analysis is necessary.
Extended analysis should focus on several different aspects of a company’s financial condition, results of operations, and future prospects. Analysis of short-term liquidity is always important because before we assess long-term solvency we want to be satisfied about the near-term financial survival of the company. We described various analyses of short-term liquidity already in this chapter. Loan and bond indenture covenants requiring maintenance of minimum working capital levels attest to the importance of current liquidity in ensuring a company’s long-term solvency. Additional analytical tests of importance include the examination of debt maturities (as to amount and timing), interest costs, and risk-bearing factors. The latter factors include a company’s earnings stability or persistence, industry performance, and composition of assets.
Asset-Based Measures of Solvency
This section describes two categories of asset-based analyses of a company’s solvency.
(b) Asset Composition in Solvency Analysis
The assets a company employs in its operating activities determine to some extent the sources of financing. For example, fixed and other long-term assets are typically not financed with short-term loans. These long-term assets are usually financed with equity capital. Debt capital is also a common source of long-term asset financing, especially in industries like utilities where revenue sources are stable. Asset composition analysis is an important tool in assessing the risk exposure of a company’s capital structure. Asset composition is typically evaluated using common-size statements of asset balances. Further analysis and measurements might alter or reinforce this preliminary interpretation.
(C) EARNINGS COVERAGE
Introduction
One limitation of capital structure measures is their inability to focus on availability of cash flows to service a company’s debt. As debt is repaid, capital structure measures typically improve, whereas annual cash requirements for paying interest or sinking funds remain fixed or increase (examples of the latter include level payment debt with balloon repayment provisions or zero-coupon bonds) This limitation highlights the important role of a company’s earnings coverage, or earning power, as the source of interest and principal repayments. While highly profitable companies can in the short-term face liquidity problems because of asset composition, we must remember that long-term earnings are the major source of liquidity, solvency, and borrowing capacity.
EARNINGS COVERAGE MEASURES
i. Earnings to Fixed Charges Ratio
Relation of Earnings to Fixed Charges
Earnings coverage measures focus on the relation between debt-related fixed charges and a company’s earnings available to meet these charges.
Securities and Exchange Commission regulations require that the ratio of earnings to fixed charges be disclosed in the prospectus of all debt securities registered. The typical measure of the earnings to fixed charges ratio is:
= Earnings available for fixed charges
Fixed charge
Computing Fixed Charges
The second major component in the earnings to fixed charges ratio is fixed charges. In this section we examine the fixed charges typically included in the computation. Analysis of fixed charges requires consideration of several important components which include:
Interest Incurred. Interest incurred is the most direct and obvious fixed charge arising from debt. We can approximate the amount of interest incurred by referring to the mandatory disclosure of interest paid in the statement of cash flows. Interest incurred differs from the reported interest paid due to reasons that include; changes in interest payable, interest capitalized being netted and discount and premium amortization.
In the absence of information, interest paid is a good approximation of interest incurred.
Interest Implicit in Lease Obligations. When a lease is capitalized, the interest portion of the lease payment is included in interest expense on the income statement, while most of the balance is usually considered repayment of the principal obligation. A question arises when our analysis discovers certain leases that should be capitalized but are not. This question goes beyond the accounting question of whether capitalization is appropriate or not. We must remember a long-term lease represents a fixed obligation that must be given recognition in computing the earnings to fixed charges ratio.
Preferred Stock Dividend Requirements of Majority-Owned Subsidiaries. These are viewed as fixed charges because they have priority over the distribution of earnings to the parent. Items that would be or are eliminated in consolidation should not be viewed as fixed charges.
We must remember that all fixed charges not tax deductible must be tax adjusted. This is done by increasing them by an amount equal to the income tax required to yield an after-tax income sufficient to cover these fixed charges. The preferred stock dividend requirements of majority- owned subsidiaries are an example of a nontax-deductible fixed charge. We make an adjustment to compute the “gross” amount:
= Preferred stock dividend requirements
1 - Effective tax rate
Principal Repayment Requirements. Principal repayment obligations are from a cash outflow perspective as onerous as interest obligations.
Guarantees to Pay Fixed Charges. Guarantees to pay fixed charges of unconsolidated subsidiaries or of unaffiliated persons (entities) should be added to fixed charges if the requirement to honor the guarantee appears imminent.
Other Fixed Charges. A thorough analysis of fixed charges should include all long-term rental payment obligations (not only the interest portion), and especially those rentals that must be met under non-cancelable leases. The reason short-term leases can be excluded from consideration in fixed charges is they represent obligations of limited duration, usually less than three years. Consequently, these leases can be discontinued in a period of financial distress.
Earnings to fixed charge ratio = Earnings available for debt service
Interest + instalment payment
Interpretation
This is used to judge the firm’s ability to pay off current interest and other fixed charges (instalments). The bigger the ratio the better.
ii. Times Interest Earned Analysis
Another earnings coverage measure is the times interest earned ratio. This ratio considers interest as the only fixed charge needing earnings coverage:
= Earnings before income taxes (EBIT) + Interest expense
Interest expense
The times interest earned ratio is a simplified measure. It ignores most adjustments to both the numerator and denominator that we discussed with the earnings to fixed charges ratio. While its computation is simple, it is potentially misleading and not as effective an analysis tool as the earnings to fixed charges ratio.
Interpretation
Times interest earned shows how well operating profit (EBIT) covers our interest obligations.
A high ratio means that the company can easily meet its interest obligation. A lower ratio indicates excessive use of debt or inefficient operations.
iii. Cash Flow to Fixed Charges Ratio
The cash flow to fixed charges ratio is computed using cash from operations rather than earnings in the numerator of the earnings to fixed charges ratio. Cash from operations is reported in the statement of cash flows. The cash flow to fixed charges ratio is defined as:
= Cash flow from operations
Fixed charges
iv. Earnings Coverage of Preferred Dividends
Our analysis of preferred stock often benefits from measuring the earnings coverage of preferred dividends. This analysis is similar to our analysis of how earnings cover debt related fixed charges. The SEC requires disclosure of the ratio of combined fixed charges and preferred dividends in the prospectus of all preferred stock offerings. Computing the earnings coverage of preferred dividends must include in fixed charges all expenditures taking precedence over preferred dividends. Since preferred dividends are not tax deductible, after-tax income must be used to cover them. Accordingly, the earnings coverage of preferred dividends ratio is computed as follows.
= Earnings after tax (EAT)
Fixed charge + (Preference dividends}
1-Tax rate
Interpretation
It measures the ability of the company to pay dividends on the preference shares. The bigger the better.
Case Example
Sahan Company Ltd
Income statement as at 30th June 2018
Net sales
13,400,000
Other Incomes
600,000
Total Revenue
14,000,000
Cost of goods sold
7,400,000
Operational expenses
1,900,000
Depreciation
800,000
Interest expense
700,000
Rent expense
800,000
Minority interest
200,000
(11,800,000)
Income before taxes
2,200,000
Current income tax
800,000
Deffered income tax
300,000
(1,100,000)
Net income before other item
1,100,000
Extra ordinary gain
200,000
Net income
1,300,000
Dividends
Dividends on common stock
200,000
Dividends on Preferred. S
400,000
(600,000)
Retained earning
700,000
Selected notes to financial statements:
1 Depreciation includes amortization of previously capitalized interest of $80,000.
2 Interest expense consists of:
Interest incurred (except items below) . . . . . . . . . . . . . . . . . . . . . . . . . . $740,000
Amortization of bond discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Interest portion of capitalized leases . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Interest capitalized. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (200,000)
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $700,000
3 Interest implicit in non-capitalized leases amounts to $300,000.
4 These subsidiaries have fixed charges.
Additional information (for the income statement period):
Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $310,000
Increase in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180,000
Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000
Decrease in accrued taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Earnings to Fixed Charges Ratio
Given the above Sahan income statement numbers, we compute Earnings to fixed charges as follows:
= Earnings available for fixed charges
Fixed charge
= 2,200 +700 +300 +80 - 600 +200
840 +60 +300 = 2.4
Times interest earned
= Earnings before income taxes (EBIT) + Interest expense
Interest expense
= 2,200+700 = 4.14
700
Earnings Coverage of Preferred Dividends
= Earnings after tax (EAT)
Fixed charge + (Preference dividends}
1-Tax rate
2,200 +700 +300 +80 - 600 +200
840 + 60 +300 +400
1-0.5
= 1.44
Capital Structure Risk and Return
It is useful for us to consider recent developments in financial innovations for assessing the risk inherent in a company’s capital structure. A company can increase risks (and potential returns) of equity holders by increasing leverage.
Another potential benefit of leverage is the tax deductibility of interest-dividends paid to equity holders are not tax deductible. Still, substitution of debt for equity yields a riskier capital structure. This is why bonds used to finance certain leveraged buyouts are called junk bonds.
Bond Credit Ratings
The bond credit rating is a composite expression of judgment about the creditworthiness of the bond issuer and the quality of the specific security being rated. A rating measures credit risk where credit risk is the probability of developments unfavorable to the interests of creditors. This judgment of creditworthiness is expressed in a series of symbols reflecting degrees of credit risk. The top four rating grades from Standard & Poor’s are as follows:
AAA Bonds - rated AAA are highest-grade obligations. They possess the highest degree of protection as to principal and interest. Marketwise, they move with interest rates and provide maximum safety.
AA Bonds - rated AA also qualify as high-grade obligations and in the majority of instances differ little from AAA issues. Here, too, prices move with the long-term money market.
A Bonds - rated A are regarded as upper-medium grade. They have considerable investment strength but are not free from adverse effects of changes in economic and trade conditions. Interest and principal are regarded as safe. They predominantly reflect money rates in their price behavior, and to some extent economic conditions.
BBB Bonds - rated BBB, or medium-grade category, are borderline between sound obligations and those where the speculative element begins to predominate. These bonds have adequate asset coverage and normally are protected by satisfactory earnings.
Factors to consider when rating Debt
i. Asset protection – This refers to the extent a company’s debt is covered by its assets. One measure is net tangible assets to long-term debt.
ii. Financial resources – This refers to liquid resources like cash and working capital accounts. Analysis measures include the collection period of receivables and inventory turnover.
iii. Future earning power - is an important factor in rating debt securities because the level and quality of future earnings determine a company’s ability to meet its obligations, especially those of a long-term nature. Earning power is usually a more reliable source of protection than assets.
iv. Management’s abilities, foresight, philosophy, knowledge, experience, and integrity are important considerations in rating debt.
v. Debt provisions are usually written in the bond indenture.
REFERENCES
Wild J.J., K. R Subranyam and R.B. Hasley., Financial Statement Analysis, McGraw-Hill 11th, Edition, 2014.
Comiskey E Eugene & C. W Mulford., Guide to Financial Reporting and Analysis, John Wiley and Sons ,2010