Understand solvency ratios
Solvency ratios show a company’s financial health in relation to its debt. As you can imagine, there are several different ways to measure financial health.
Debt to Equity
Debt-to-Equity is a fundamental indicator of the level of leverage a company is using. Debt generally refers to long-term debt, although cash that is not needed to run a business could be netted against total long-term debt to give a net debt figure.
Equity refers to the equity or book value that can be found on the balance sheet. The book value is a historical value that ideally is written down (or written down) to its market value. But with what the company reports, it gives a quick and easily available number that can be used for measurements.
Debt to Assets
Asset leverage is a closely related metric that also helps an analyst or investor measure leverage on the balance sheet. Since assets minus liabilities are equal to book value, using two or three of these items provides a good look at financial health.
More complicated solvency measures include interest income, which is used to measure a company’s ability to meet its liabilities. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the total interest expense from long-term debt. It specifically measures how often a company can cover its interest expenses before taxes. Interest coverage is another more general term used for this ratio.
Solvency vs. Liquidity Ratios
The solvency ratio measures a company’s ability to meet its long-term obligations, as shown by the formula above. Liquidity metrics measure short-term financial health. The current ratio and quick ratio measure a company’s ability to cover short-term liabilities with liquid assets (with a term of one year or less). These include cash and cash equivalents, securities and trade receivables.
Current debt includes liabilities or inventories that need to be paid. Basically, solvency ratios look at long-term debt, while liquidity ratios look at working capital positions on a company’s balance sheet. In the case of liquidity ratios, assets are in the numerator and liabilities in the denominator.
What these metrics tell an investor
Solvency ratios are different for different companies in different industries. For example, food and beverage companies, as well as other consumer staples, can generally bear a higher debt burden because their profit levels are less prone to economic fluctuations.
In stark contrast, cyclical companies need to be more conservative as a recession can hurt their profitability and leave less buffer to cover debt repayments and related interest expenses during a downturn. Financial firms are subject to different state and national regulations that set solvency ratios. Falling below certain thresholds could trigger the wrath of regulators and premature calls to raise capital and hedge low quotas.
Acceptable solvency ratios vary from industry to industry, but as a general rule of thumb, a solvency ratio greater than 20% is considered financially sound. The lower a company’s solvency ratio, the greater the likelihood that the company will fail to meet its liabilities.
Considering some of the above ratios, a debt to wealth ratio of over 50% could be cause for concern. A debt-to-equity ratio of over 66% is cause for further investigation, especially for a company operating in a cyclical industry. A lower rate is better when debt is in the meter and a higher rate is better when assets are part of the meter. Overall, having more wealth or more profitability compared to debt is a good thing.
An analysis of European insurance companies from July 2011 by the consulting firm Bain shows how solvency ratios affect companies and their survivability, how they reassure investors and customers about their financial health and how the regulatory environment plays a role.
The report shows that the European Union has been introducing stricter solvency standards for insurance companies since the Great Recession. The rules known as Solvency II set higher standards for property and casualty insurers as well as life and health insurers. Bain concluded that Solvency II “shows significant weaknesses in the solvency ratios and risk-adjusted profitability of European insurers”.
The most important solvency ratio is wealth to equity, which measures how well an insurer’s assets, including its cash and investments, are covered by solvency capital, which is a specialized book value measure made up of capital that is in a downturn can be used easily. This includes, for example, assets like stocks and bonds that can be sold quickly if the financial condition deteriorates rapidly, as it did during the credit crunch.
An example from practice
MetLife (NYSE: MET) is one of the largest life insurers in the world. A current analysis from October 2013 shows that the ratio of debt to equity of MetLife is 102% or that the reported debt is slightly above equity or the book value in the balance sheet. This is an average debt level compared to other companies in the industry, meaning roughly half of the competitors have a higher rate and half have a lower rate.
The ratio of total liabilities to total assets is 92.6%, which is not so good compared to the ratio of debt to equity, as around two thirds of the industry have a lower ratio. MetLife’s liquidity metrics are even worse, at the bottom end of the industry when you look at the current ratio (1.5x) and the fast ratio (1.3x). However, this is not a cause for concern as the company has one of the largest balance sheets in the insurance industry and is generally able to fund its short-term commitments.
Overall, from a solvency perspective, MetLife should be able to easily finance its long and short term debts as well as interest payments on its debts.
Context is key
Solvency ratios are extremely useful in analyzing a company’s ability to meet its long-term commitments. But like most financial metrics, they must be used as part of an overall business analysis.
Investors need to look at the overall investment appeal and decide whether a security is undervalued or overvalued. Debtors and regulators may be more interested in solvency research, but they still need to consider a company’s overall financial profile, its pace of growth, and its overall good governance.
The bottom line
Credit analysts and regulators have a keen interest in analyzing a company’s solvency metrics. Other investors should use them as part of a comprehensive toolkit to study a company and its investment prospects.