Solvency Ratios
A company’s solvency is its ability to pay off long-term debts, and obligations. Solvency ratios are important for owners because it shows the level of debt the company holds relative to the profit it generates, and how a company funds their purchases. As long as a company generates, or has, enough cash to pay interest, and the debt principal, on time it won’t go bankrupt.
When we talked about liquidity, we noted how a company could have liquidity issues, due to a mismatch of cashflow timing and liability obligations, but still be “solvent”. Liquidity issues are not necessarily terminal. If a company can find the needed cash – either internally or with a short-term loan – liquidity problems are temporary. If a company can’t pay off its liabilities the owners will likely lose their company.
To look at a company’s overall indebtedness we use Net Debt.
Net Debt = Total Debt – Cash
If a company uses all their cash to pay down total existing debt the remaining amount is its Net Debt. The Net Debt amount must be paid with cash generated by the business.
To analyse the indebtedness, we compare the size of Net Debt relative to profits, or cash, generated. The “relative” analysis gives us an approximate idea of how long a company could repay lenders.
For West Pharmaceuticals we can see that they have more cash than debt – a “net cash” position”.
Relative Leverage
FOR ILLUSTRATION’S SAKE ASSUME WEST PHARMACEUTICALS HAS $1,000 OF NET DEBT
I REPEAT – FOR THE SAKE OF DOING THE CALCULATIONS ASSUME WEST PHARMACEUTICALS HAS $1,000 OF NET DEBT
EBIT, also known as Operating Profit, is calculated as Revenue minus 1) Cost of Goods Sold 2) Operating Expenses. Use colour codes on the Income Statement below to follow the maths.
Since EBIT excludes interest and taxes it measures the profit of “core” operations. Put another way, EBIT is the profit before taxes if the company has no debt.
Comparing Net Debt levels to EBIT gives us a good idea, of how long it would take us to pay down our debt using a company operating profit. For an SMB, anything more than 2.5x EBIT would be risky.
EBITDA, or Earnings Before Interest, Tax, Depreciation and Amortization, another metric once can use. The metric is EBIT plus depreciation and amortization expenses. Let’s ignore amortization for now – it is not common for SMBs but we can discuss it another time.
Accountants use depreciation expense to represent the economic degradation of PP&E equally over the asset’s lifetime. Crucially, deprecation expense is non-cash. Let us go over that.
PP&E is purchased upfront – (“Capital Expenditure”). Since PP&E lasts longer than one year (generally 5-10 years), accounting delays the expense of the PP&E purchase to match the useful life of the asset. The asset’s “depreciation”, and thus depreciation expense is recognized over its lifetime.
The PP&E has already paid for upfront in a prior period. So, depreciation expenses are non-cash. Depreciation expenses are just a representation of the cost of the PP&E purchase if one could buy the PP&E in equal portions.
Depreciation expenses are not cash outflows like employees’ wages. Accounting “smooths” the large cash outflow from the initial purchase and equally in all years the asset is used. The Income Statement, therefore, better represents the underlying business economics.
So why have I spent time reexplaining this? Well as you can probably tell EBITDA affects the cash generated by a business. In the previous ratio, we used EBIT (Operating Profit) to approximate the actual cash generated that we can use to repay debt. However, as we just went through, EBITDA gives us a better idea of the cash coming into our bank account. EBIT will understate the cash coming into our bank accounts in a year. EBITDA will better estimate the cash a business generates from sales.
Therefore, Net Debt to EBITDA is a helpful ratio assessing how much debt relative is held relative to the yearly cash a business will generate (cash flow). For an SMB, I would be very concerned if I saw a Debt to EBITDA ratio of more than 2x. SMB revenues can be very volatile and are easily affected by exterior forces. What was 2x EBITDA last year, could be 5x in a recession…
See the picture on the right to see the EBITDA calculation. We are using the same EBIT, or Operating Profit in the income statement above. However, you may notice there are no depreciation & amortization expenses (“D&A”) in other line items. Instead of having a separate D&A expense line, public company accountants sometimes “embed” D&A in other items. Since D&A are non-cash expenses we can look at the cash flow statement to find the amount.
EBIT + Deprecation & Amortization = EBITDA
= 676 + 133.7 + 3.6 = 813.3
The EBITDA less CapEx Leverage Ratio builds on the prior ratio. Capital expenditures (“CapEx”) are funds used by a company to acquire, upgrade, and maintain fixed/non-current assets such as property, plants, equipment, buildings, or technology.
Companies spend on CapEx for two main reasons: 1) Maintain – service existing PP&E assets to offset depreciation and extend lifetime, and 2) Grow – new PP&E or upgrade PP&E to add capacity. Thus, CapEx directly impacts whether we can 1) maintain revenue or 2) grow revenue.
CapEx is reinvesting the cash produced back into the business. Look back to the table above. Purchases of PP&E represent an upfront cash outflow. Therefore, if a company is reinvesting back into the business, we cannot use that cash to pay down debt. We need to subtract CapEx from EBITDA to arrive at a better proxy for our cash flow! Thus, EBITDA less CapEx helps us better understand our ability to pay down debt, or solvency.
Some sharp financiers among you will point out that you can delay CapEx – purchase PP&E a year later. You can do this and is up the to discretion of business owners/the management team. However, delaying CapEx may mean your PP&E breaks down, is not maintained and you lose production capacity. To get a better idea of how much cash a business is generating we should subtract CapEx from EBITDA.
Expert Point
What would it mean if D&A equals CapEx?
Depreciation brings our Net PP&E value down while CapEx increases our Net PP&E value. Therefore, we can conclude that our PP&RE assets are depreciating at the same rate that we are replacing them – Net PP&E won’t change from one year to the next. Think about this… CapEx that only replaces existing levels Net PP&E is only maintaining our current production capacity or revenue levels. We will discuss this more in the post on Free Cash Flow.
Interest Payment Ratios
There are two parts to remaining solvent. The first is your company’s ability to pay down debt – principal paydown. The second part is paying interest expenses on time. If interest payments are late, or not able to be paid, then a bank can foreclose on a loan. I.e. a company defaults on its loans. Unless the lender agrees to renegotiate the terms, the business is bankrupt.
As an owner, you want to not only want to easily pay down any debt on the balance sheet, but we also need to make sure interest payments can be made on time.
Interest Coverage Ratio
The Interest Coverage Ratio compares how much EBIT (Operating Profit) a company is making in a year vs the interest expenses. The ratio will indicate how comfortably a company can pay off interest expenses.
There are no fixed guidelines about what this ratio should be. If ICR is 1x or less then all your operating profit is going towards paying interest expenses, without paying down any debt. Clearly, this would not be a good situation.
Similarly, an ICR of 2x would imply half of your operating profit is paying interest instead of being A) invested back into the business or B) taken out of this business as dividends (cash to take home to the bank). A low ICR ratio indicates that a business is financially burdened by interest expenses, and its ability to comply with the terms of its debt is doubtful.
Ultimately, the “optimal” ICR is dependent on the business. If your business is very sensitive to changes in the economy, cyclical or volatile for other reasons, then a higher ICR ratio is better. If your business is very stable with very little fluctuation in revenue and profits, it may be able to sustain a lower ICR – LOWER NOT LOW.
I recommend being conservative with debt levels, and ICR. You can lose everything if you go bankrupt. Why take that risk for a chance of a little extra profit? To me, that doesn’t make sense and is not advisable.
Times Interest Earned Ratio
[Insert calculation picture with ICR & TIER]
The TIER is the same as the ICR except swapping EBIT for EBITDA. The TIER better approximates our ability to pay interest with the cash produced by the business. However, if the TIER is low, a company is at risk of being forced to divert cash from growing/replacing PP&E to pay interest.
N.B.
Be sure to know if your debt is Fixed (set and constant interest rate), or Floating (interest rate can move up or down). If your interest rate is floating, then a sudden increase in interest rates may change what is now a very high ICR into a low ICR. Therefore, if your debt interest is floating rate it would be a good idea to stress test your ICR. Work out the interest expense at 3%-4% higher than what it currently is, when analysing your interest payment ratios (ICR and TIER) to see how it changes. It never hurts to be cautious, and add a margin of safety in business preparation
Both solvency ratios A) Relative Leverage and B) Interest Service must be looked at together not individually, and in tandem with liquidity ratios.
Solvency & Liquidity Ratio
(Debt principal refers to debt outstanding)
The Debt Service Coverage Ratio is a ratio that I recently found. I really like the ratio a lot so let’s break it down.
For the numerator, we can use EBIT or EBITDA. We have already explained the differences between the two metrics – they tell similar stories but EBITDA better approximates cash inflows. However, EBIT is a better approximation for the underlying operating profit of a company before tax. This is because while depreciation is a non-cash expense, PP&E needs to be replenished and replaced. Thus depreciation expense is a real economic expense, despite being non-cash.
The denominator is very interesting. The denominator adds interest expenses and the portion of debt due in 12 months. Cumulatively, the denominator shows how much cash a company needs to produce to satisfy its financial obligations.
The ratio shows how much profit a company makes for every dollar it uses to pay off its debts. If all your profit goes towards paying off interest and debt then you as the owner are taking a lot of risk because if your EBIT or EBITDA drops you can face problems. In addition, you may starve your business of capital needed to grow or maintain your existing production capacity.
We can see the DSCR ratio is a combination of solvency ratios and liquidity ratios. It is a good indicator of a business’s short-term financial health.