How To Determine The Solvency Of A Firm

Avoid investing in firms that will become bankrupt

Author

Dr. Dividend
July 10, 2023

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Today I'll be sharing what solvency is, why it’s crucial for investors to look at, and the ratios you can use to judge a company’s solvency.

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Now for today’s piece:

How To Determine The Solvency Of A Firm

Highlights

If you only have a few minutes to spare, here are some takeaways about solvency:

• Solvency is a company's ability to meet its long-term financial obligations and repay its debts.

• The Debt-to-Equity ratio, Interest Coverage Ratio, and Current Ratio are all useful metrics for assessing a company's solvency.

• In the event of bankruptcy, secured creditors are paid first, followed by unsecured creditors, and then stockholders.

• Investing in solvent companies helps stave off the threat of bankruptcy.

Introduction

Before digging into what Solvency is, it would be helpful to review the accounting equation:

Assets = Liabilities + Shareholders’ Equity

Assets are something of value that the firm owns, like cash, accounts receivable, land, or inventory.

Liabilities are something the firm owes, like accounts payable, loans, salaries, or mortgages.

Shareholders’ Equity is what’s left over after the liabilities are subtracted from the assets. It is what would be paid out to shareholders in the event that the company was to be liquidated.

Keep this accounting equation in mind as we dig into solvency.

What Is Solvency?

Solvency is a firm’s ability to meet its long-term financial obligations and repay its debts.

It measures a company’s financial stability and indicates whether it has sufficient assets or income to cover its liabilities.

A company with positive Shareholders’ Equity means that it has enough assets to cover its liabilities and is said to be solvent.

A company with negative Shareholders’ Equity means that it does not have enough assets to cover its liabilities and is said to be insolvent.

When a firm is considered insolvent, that can lead to problems for you as an investor, such as bankruptcy.

What Happens When A Firm Declares Bankruptcy?

According to the Securities & Exchange Commission (SEC), this is the order in which a firm’s assets are divided in the event of bankruptcy:

  1. Secured Creditors - often a bank, are paid first.

  2. Unsecured Creditors - such as banks, suppliers, and bondholders, have the next claim.

  3. Stockholders- owners of the company, have the last claim on assets and may not receive anything if the Secured and Unsecured Creditors' claims are not fully repaid.

As you can see, stockholders would be the last people to be repaid anything if a company they were invested in were to declare bankruptcy.

Luckily there are a few ways you as an investor can assess the solvency of a firm you’d like to invest in, and that can ultimately save you from investing in firms that may become bankrupt.

I like to look at 3 solvency ratios, the first of which is the Debt-to-Equity ratio (D/E).

Debt To Equity (D/E)

The D/E is a measure of a company's total debt compared to its shareholders' equity. It is calculated by dividing total debt by shareholders' equity.

The ratio compares how much growth is financed by debt as opposed to how much growth is financed by equity.

A higher debt-to-equity ratio indicates higher financial risk, as it suggests that a larger portion of the company's assets is funded by debt.

When looking at D/E, I compare the firm I’m interested in with the D/E of its competitors to see how efficient the company I’m interested in is with utilizing debt and equity.

Companies with a D/E below 1 indicate that their debts do not exceed their shareholders’ equity, which is a sign of a healthy balance sheet.

One company that fits this description is Costco. The firm has been able to keep its debt low and still find ways to grow revenue and profits over time.

This low D/E Ratio of 0.28 means that for every dollar of equity Costco shareholders have, the firm only has 28 cents worth of debt.

Interest Coverage Ratio

The Interest Coverage ratio is a measure of how well a firm can pay the interest on its debts.

It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense.

The ratio indicates the number of times a company's operating income covers its interest expenses.

A higher interest coverage ratio suggests that the company is more capable of servicing its interest payments, indicating lower financial risk.

One of my favorite stocks with a high interest coverage ratio is Visa. Its EBIT can cover its interest expense 34.77x over!

Current Ratio

The current ratio is a measure of a company's ability to pay its short-term debts.

It compares a company's current assets (such as cash, accounts receivable, and inventory) to its current liabilities (such as accounts payable and short-term debt).

A higher current ratio means the company has more current assets to cover its current liabilities, indicating better short-term financial health and the ability to meet its immediate payment obligations.

I’ll use Visa again as an example of a company with an outstanding current ratio:

For every dollar of current liabilities Visa has, it has $1.50 worth of current assets.

Final Thoughts

For a firm to remain in business, it needs to be solvent in the short term and in the long term.

In the short term, the firm needs to have liquidity to cover its near-term obligations, such as accounts payable and short-term debt. The Current Ratio can measure this.

In the long term, the firm needs to be certain that it can pay its debts.

It's essential to make sure that companies aren’t just pushing their debt obligations further out into the future to make the short-term look good.

This can be measured by the D/E ratio which looks at the amount of debt the firm has in relation to its shareholder equity, as well as the Interest Coverage Ratio which measures how well a firm can pay the interest on its debts.

Use these metrics to ensure that the firms you’d like to invest in can pay their bills, grow organically and remain solvent.

It will help you avoid investing in firms that may be facing bankruptcy.

Until next time,

Dr. “Solvency” Dividend

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