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The Connection Between Leverage and Solvency
A business uses a combination of debt and equity to begin and maintain operations. Loans are often obtained to purchase equipment, fixtures and inventory. Equity is contributed by owners or shareholders and builds with earnings that are retained for growth. Both types of capitalization are appropriate. But, the degree to which a business uses debt to produce income, also known as leverage, impacts long-term solvency.
A business must be able to make principal and interest payments and continue profitable operations even through cyclical and economic downturns. A company that is too highly leveraged may become financially strained and end up bankrupt.
All categories of ratio analysis, including liquidity and profitability, provide information about financial viability. However, solvency ratio analysis provides a measure of whether a company is using a successful debt strategy and will likely remain solvent in the long-run. As with all ratio analysis, the results provide early indicators to problems and suggest areas that require further investigation.
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The debt ratio is commonly used to assess debt structure.
The calculation: Total Liabilities / Total Assets = Debt Ratio
Example: $300,000 / $500,000 = 0.6
Where to get the numbers: Total Liabilities is a total on the Balance Sheet and includes all short- and long-term liabilities. Total Assets also represents a total on the Balance Sheet and includes all assets of the company. Note that lease obligations and other special financing arrangements are included in the analysis.
What it means: The debt ratio shows what percentage of a company's assets are financed through debt. In the example, approximately 60% of the company's assets are financed through debt. A ratio that approaches 1 shows that a business is mostly financed by debt. Large interest payments can limit the amount of cash on hand and cut into profits.
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Debt to Equity Ratio
The debt to equity ratio provides another measure of leverage and solvency.
The calculation: Total Liabilities / Total Equity = Debt to Equity Ratio
Example: $100,000 / $300,000 = 0.3
Where to get the numbers: Total Liabilities are a total on the Balance Sheet and include all short- and long-term liabilities. Total Equity also represents a total on the Balance Sheet.
What it means: The Debt to Equity ratio measures the balance between capitalization provided by owners or stockholders as compared to financing provided by creditors. In the example, total liabilities represent about 30% of total equity. An increasing amount of debt as a percentage of equity indicates that the company is funding operations and growth through creditors rather than through earnings. A lower number indicates that the company has the capacity to seek outside financing as needed. A company is generally expected to have a ratio less than 0.5 and the specific number varies by industry.
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Times Interest Earned Ratio
The times interest earned ratio, also known as the interest coverage ratio, measures the company's ability to pay interest payments.
The calculation: Income Before Interest and Taxes / Interest Expense = Times Interest Earned
Example: $45,000 / $15,000 = 3 times
Where to get the numbers: Earnings Before Interest and Taxes or EBIT as well as Interest Expense is taken from the Income Statement.
What it means: The Times Interest Earned ratio measures the number of times that operating income can cover interest expense. In the example above, income would cover interest expense 3 times. A high number indicates an ability to pay interest and a low number suggests future problems. This number is generally expected to be higher than 1.5, but varies by industry.
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What's A Good Number?
Solvency ratio analysis is an objective tool that can help assess a company's long-term well-being. In order to produce a meaningful analysis, the calculations should be based on common size financial statements prepared in accordance with generally accepted accounting principles. The user should be familiar with the underlying accounts and understand the company and environment in which it operates. It is extremely helpful to look at ratios over several years and compare them with similarly situated companies. Resources available to assist in identifying benchmark ratios by industry are available through The Risk Management Association and Bizstats.com.
Credit Image: http://www.sxc.hu/photo/124128
Reference:Needles, Jr. Belverd E., and Marian Powers. Financial Accounting. 9 ed. Boston: Houghton Mifflin Company, 2007. Print.