Solvency Analysis

The solvency of a business entity is important to both its internal and external stakeholders. The solvency of a business entity measures its ability to pay its debts as they become due, thus gauging the viability of the firm in the long term. It examines both the long-term and short-term cash flow of a business entity. Across industries there are two common solvency analysis measures: debt-to-equity ratio and times interest earned ratio.

The debt-to-equity ratio is used to measure how a company has financed its business through debt, stockholders’ equity, or a combination of both. The components of the debt-to-equity ratio include total liabilities and total stockholders’ equity, and can be extracted from the balance sheet. Total liabilities include both short-term and long-term debt. Operating liabilities, such as accounts payable, are also included in this ratio. Though they are not forms of traditional debt, they still must be paid back or settled. One benchmark to consider is a debt-to-equity ratio of one or less. A ratio greater than one would indicate that the business entity depends more heavily on debt than on equity financing. The challenge with debt is that the borrower must pay interest and principal according to the lender's terms, the same way a mortgage or car loan is paid. The lender controls the cash outflows. Conversely, under equity financing, ownership is given up, but equity financing allows the company to control cash outflows, such as dividends paid.

Charlie's Camper Company has the following information on the balance sheet: total liabilities at $1,120,000 and total stockholders' equity at $2,800,000. A debt-to-equity ratio of 0.4 for Charlie’s Camper Company means that they rely more on equity than debt. This means that they rely less on debt and more on equity to support their business. Debt carries with it the requirement to make regular payments and to pay interest, so a heavy debt load can mean increased risk. The ratio provides insights into how heavy the reliance is on debt. The ratio is not considered ‘good’ or ‘bad’, it’s merely an indicator of how the business is financed.

Another solvency analysis measure is the times interest earned ratio. The times interest earned ratio is often referred to as the interest coverage ratio, as it measures how many times a business entity's operating income can cover its interest expense. A high times interest earned ratio is preferred, as it is an indicator of the business's long-term financial strength and ability to pay off its interest expense and meet debt obligations. A low times interest earned ratio can be an indicator that the business cannot meet its debt obligations, possibly from financial difficulties. To calculate times interest earned, divide earnings before interest and tax (EBIT) into interest expense, both of which can be found on the income statement.

An illustration of the times interest earned ratio can be computed using information from Charlie's Camper Company. Based on the calculation, the business entity can pay off its interest expense 25 times with its current operating income which is a good indicator that they will be able to meet their interest expense and debt obligations.