Solvency ratios measure the sustainability of the business’s capital structure. These ratios show a company’s ability to pay off long-term obligations to creditors, bondholders, and banks. Business valuations use financial analysis to determine the value of a company. Solvency ratios are commonly used. In particular, the debt ratio and times interest earned ratio.
The debt ratio measures the financial leverage a company has. Higher debt levels tend to imply higher risk. However, debt is typically cheaper than equity and the interest paid is deductible from taxes. The formula is:
Debt Ratio = (Short-term Debt + Long-term Debt) / Total Assets
This ratio is commonly shown in decimal format as it calculates total debt as a percentage of total assets. A lower ratio is more favorable than a higher ratio. A lower debt ratio implies a more stable business as it has a less debt.
Each industry has benchmarks, but 0.5 or less is reasonable. A debt ratio of 0.5 means a company has twice as many assets as debt. The higher the ratio the higher degree of leverage and consequently, more risk for lenders. Companies with higher debt ratios are better off looking at equity financing to grow their operations.
Times Interest Earned Ratio
The times interest earned ratio measures the ability of the business to pay interest on debt using current operating income. This ratio is sometimes called the interest coverage ratio. The formula is:
Times Interest Earned = Operating Income (EBIT) / Interest Expense
*EBIT = Earnings Before Interest and Taxes
This ratio is commonly stated in a number as opposed to a percentage. This ratio indicates how many times a company can pay interest with before tax income. Higher ratios show more creditworthy and financially sound companies. While lower ratios indicate a higher probability of a company defaulting.
A ratio of 3 means a company makes enough income to pay for its total interest expense 3 times over. Creditors favor companies with a higher times interest earned ratio as it shows the company can afford to pay the interest when it comes due. For instance, many SBA lenders look for a ratio of 1.25. A company needs to have more than enough earnings to cover interest payments.
Ratios in Use
Analyzing solvency ratios over time gives a clearer picture of the company’s position and trajectory. One can identify trends and gain an idea of whether ratios are improving or declining. These ratios can then be compared to similar companies. This analysis aides in investment decision making.
Using these ratios can help you assess the overall financial health of your company. We at Peak Business Valuation would love to help you understand your financial analysis and are happy to answer any questions you have. Please reach out via email or through a phone call.