How to determine the solvency of a company?
Solvency is the ability of a company to meet it’s long term financial obligations. The company is considered solvent when the current assets exceed the current liabilities. To calculate the solvency there are a few ratios to consider:
- Debt to asset ratio
- Debt to equity ratio
37.1 Debt to asset ratio
When there is more debt than assets, that means the company is owned by creditors and not by it's owners.
37.1.1 How to use debt to asset ratio
- Lower is better
- below 1 (100%) is considered healthy (always use industry average)
- Can be very different between industries
- Can be used to compare companies
37.1.2 Why do investors use the debt to asset ratio in their analysis
It shows how much debt the company used to finance its assets.
37.1.3 Things to be aware of
- Only compare with other companies in the same industry
- Some companies can have higher debt to assets ratio's (for example, banks).
37.1.4 How to calculate debt to asset ratio
- Debt to asset ratio = total debt / total assets]
37.1.5 Real life example
The debt to total assets ratio shows if the company is owned by creditors or shareholders. Or in other words, the total debt in relation to the total amount of assets. It shows how much debt the company used to finance its assets.
If the ratio is 0,6, that means that 60% is financed by creditors and 40% is financed by its owners (shareholders). In this case, a higher ratio means more risk because most of the company is financed by creditors. A ratio above 1 means the company is funded by credit and took on many loans.
37.2 Debt to equity ratio
Shareholders equity = total assets - total liabilities. What's leftover after all liabilities (debt) are paid off is called shareholders equity.
37.2.1 How to use debt to equity ratio
- Lower is better
- below 2 is considered healthy (always use industry average)
- Can be very different between industries
- Can be used to compare companies
37.2.2 Why do investors use the debt to equity ratio in their analysis
It shows how much debt the company used to finance their operations.
37.2.3 Things to be aware of
- Only compare with other companies in the same industry.
- Not all debt is equally risky (for example, short term risk is less risky).
37.2.4 How to calculate debt to equity ratio
Debt to equity ratio = total debt / shareholders equity
37.2.5 Real life example
Debt to equity measures the total debt versus the total shareholders equity. While the total debts to total assets ratio uses total assets, the debt to equity ratio looks at the total equity of shareholders. Where equity of shareholders are:
- Common shares
- Preferred shares
- Retained earnings (net profits after dividend payments)
You can find the shareholders' equity in the balance sheet. A ratio between 0,5 and 1,5 is preferred. If the ratio is above 1.5, that would indicate creditors have significantly more stake (debt) in the company than the shareholders. In other words, the company is using a lot of debt to finance their operations.
Not all debt is equally risky. Meaning you can adjust the ratio by including or excluding certain amounts of debt. Short term debts are less risky because they have to be paid back within one year anyway. It’s much easier to plan one year ahead versus five or ten years.
37.3 Conclusion
Now you can make more profitable investing decisions by determining the financial health of a company. We looked at:
- Profitability
- Operating Efficiency
- Liquidity
- Solvency
All have a crucial part in determining how healthy a company is. But it does not always tell the whole picture. You should always compare ratios between the same kind of companies and industries. Also, ratios may vary widely between industries. Some companies just need way more debt to operate. The above ratios should always be evaluated over time. If one or more ratios are out of line when comparing to companies in the same industry, this might be a red flag. In my tool, all of the above mentioned ratios are already calculated for every company around the world (if the data is available). There is also a notification if the result is considered good or bad. This helps you focus on the important things.
Key Concepts:
- Solvency is the ability of a company to meet it’s long term financial obligations.
- The debt to total assets ratio shows if the company is owned by creditors or shareholders. Or in other words, the total debt in relation to the total amount of assets.
- Debt to equity measures the total debt versus the total shareholders equity.
- Finding out if a company is healthy or not is done by looking at multiple parts:
- Profitability
- Operating Efficiency
- Liquidity
- Solvency
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Chapters: The Ultimate Investing Guide
- 1. Intro2. What is investing?3. What are stocks?4. Types of stocks5. Why buy stocks?6. How to buy stocks7. Store stocks8. Stock splits9. Stock quests10. What are bonds?11. Secured bonds and maturity12. How do bonds work?13. Credit rating14. Treasury bonds15. Corporate bonds16. Municipal bonds17. Agency bonds18. Bond quests19. Mutual funds20. Mutual funds earnings21. ETFs22. Why ETFs23. Index funds24. Hedge funds25. Derivatives26. Commodities27. Indices28. Overview29. Determine company value30. IPOs31. Penny stocks32. Dividends33. Financial health34. Profitability35. Operating efficiency36. Liquidity37. Solvency38. Market Evaluation39. Not only numbers40. Investing portfolio considerations41. Creating portfolio42. Buy/Sell Strategy43. Broker44. Emotions45. Final steps46. Key Concepts