The basic premise of solvency ratio analysis (also called leverage ratio analysis) is to measure whether the company has a long-term sustainable financing structure.
Thus, it is one of the cornerstones for measuring the long-term financial health of a company. As such, it is a more important tool for creditors than for investors.
Below we will dive deeper into the most commonly used solvency ratios. We will do this through defining the ratio, the formula, how to use it for solvency ratio analysis and finally, demonstrate the use of the ratio through analysis of Coca Cola and PepsiCo.
Solvency ratios are closely related to liquidity analysis (and in fact many people confuse them).
The difference is, that liquidity ratios measures the short-term ability to pay banks and other creditors. Solvency ratios are more focused on the long term.
After reading this page, you will know whether Coca Cola or PepsiCo has an unsustainable financing structure.
(Hint: They are both ok).
Debt to equity ratio
The definition of the Debt to equity ratio formula is:
It shows the proportion of the company that is financed with debt relative to the equity put into the company.
A debt to equity ratio of 1 indicates that it is financed equally be debt and equity.
In general, it is favourable to have a lower ratio.
Debt to equity ratio analysis
#1 Indicates a more stable business. A lower debt to equity ratio usually indicates a more financially stable business. This is because, it will generally have less interest payments to worry about due to a low level of debt.
#2 Creditors view a high level as risky. A high debt to equity ratio shows, that the investors have not put a lot of money into the business. This means they have less skin in the game than creditors. There could be many reasons for this, however, it implies that the investors don’t believe in the company.
Debt to equity ratio example
Looking at the debt to equity ratio, it appears that both companies are relatively highly levered. Coca Cola has $2.5 of liabilities for every dollar of equity and PepsiCo has $4.8 for every dollar of equity.
While Coca Cola’s ratio can be acceptable depending on the industry, the debt to equity ratio for PepsiCo is considered high.
So, is Pepsi in an unsustainable situation?
According to the debt to equity ratio, yes.
This is based on book value of equity.
But Pepsi is listed so we can base it on market values instead.
As of writing PepsiCo has a market cap of approx. USD 145 billion. And total liabilities of approx. USD 57 billion.
This significantly alters the picture and using these figures, PepsiCo has a debt to equity ratio of 0.39x.
This is indeed very sustainable – and the same applies for Coca Cola.
This highlights an important lesson: When you can use market values for equity you should do so.
The definition of the Equity ratio formula is:
It shows the proportion of assets that are financed by equity.
In general, higher equity ratios are favourable for the company.
Equity ratio analysis
There are several reasons why a high equity ratio is favourable:
#1 A high ratio naturally indicates, that the equity holders have invested a lot in the company. I.e. they have skin in the game. This will make it easier for creditors to finance the company
#2 A high equity ratio indicates that there is not a lot of debt in the company and thus, it is less risky to lend money to it.
#3 A company with a high equity ratio should have less interest payments to worry about. From the outside in, the company will thus seem more stable.
Also, note that equity ratio + debt ratio is always equal to 1.
The definition of the Debt ratio formula is:
It shows the proportion of assets that are financed by debt.
In general, a lower debt ratio is favourable for the company.
Debt ratio analysis
A low debt ratio is favourable for the following reasons:
#1 Indicates a more stable business. A low debt ratio implies that a company has low interest payments. As such, it can be considered more stable and signals longevity of the business.
Contrast this to a company with a high leverage ratio (close to 1). The company will have high interest payments which will make it harder to make a profit. This is almost always what happens, when companies are going bankrupt.
In general, it is a good rule of thumb that a debt ratio below 0.5 is considered reasonable.
Now it’s your turn
This concludes our introduction to solvency ratio analysis.
We encourage you to either try it yourself (that is the best way of learning) or move on to other topics within financial statement analysis, profitability ratios, efficiency ratios or liquidity ratios.
We hope you enjoyed it and if you have any comments please post them below.
Or perhaps, you have questions about a step in the process?
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So, if you have a question or a thought, leave a comment right now.