Solvency+Notes Kdgnmjpcl1

WHAT IS
SOLVENCY?
SOLVENCY IS THE ABILITY OF A COMPANY TO MEET ITS

LONG-TERM DEBTS AND OTHER FINANCIAL OBLIGATIONS.
SOLVENCY ABILITY IS RELATED TO THE EXTENT TO WHICH THE BUSINESS USES DEBT
VERSUS EQUITY FINANCING.
THE SHAREHOLDERS’ EQUITY ON A COMPANY’S BALANCE SHEET CAN BE A QUICK WAY TO CHECK
A COMPANY’S SOLVENCY AND FINANCIAL HEALTH.
THE QUICKEST ASSESSMENT OF A COMPANY’S SOLVENCY IS ITS ASSETS MINUS LIABILITIES, WHICH EQUAL ITS SHAREHOLDERS’
EQUITY
MANY COMPANIES HAVE NEGATIVE SHAREHOLDERS’ EQUITY, WHICH IS A SIGN OF INSOLVENCY.
HOWEVER, CERTAIN EVENTS MAY CREATE AN INCREASED RISK TO SOLVENCY, EVEN FOR WELL-ESTABLISHED COMPANIES. IN THE
CASE OF BUSINESS, THE PENDING EXPIRATION OF A PATENT CAN POSE RISKS TO SOLVENCY, AS IT WILL ALLOW COMPETITORS TO
PRODUCE THE PRODUCT IN QUESTION, AND IT RESULTS IN A LOSS OF ASSOCIATED ROYALTY PAYMENTS. FURTHER, CHANGES IN
CERTAIN REGULATIONS THAT DIRECTLY IMPACT A COMPANY’S ABILITY TO CONTINUE BUSINESS OPERATIONS CAN POSE AN
ADDITIONAL RISK
CAPITAL STRUCTURE AND
SOLVENCY ?
CAPITAL STRUCTURE DECISIONS AFFECT THE RISK PROFILE OF A FIRM.
FOR EXAMPLE, A COMPANY WITH A HIGHER PERCENT OF DEBT CAPITAL WILL BE

RISKIER THAN A FIRM WITH A HIGH PERCENTAGE OF EQUITY CAPITAL. THUS, WHEN
THERE IS A LOT OF DEBT, EQUITY INVESTORS WILL DEMAND A HIGHER RATE OF
RETURN ON THEIR INVESTMENTS TO COMPENSATE FOR THE RISK BROUGHT ABOUT
Equity
BY THE HIGH USE OF FINANCIAL LEVERAGE.
Debt
Equity
COMPANY WITH A HIGH LEVEL OF EQUITY CAPITAL WILL BE ABLE TO BORROW AT LOWER
RATES BECAUSE DEBT HOLDERS WILL ACCEPT LOWER INTEREST IN EXCHANGE FOR THE
LOWER RISK INDICATED BY THE EQUITY CUSHION.
Debt
Debt V/s Equity
DEBT FINANCING DOES NOT GIVE THE LENDER OWNERSHIP RIGHTS IN YOUR COMPANY. YOUR BANK OR YOUR LENDING
INSTITUTION WILL HAVE A RIGHT TO TELL YOU HOW TO RUN YOUR COMPANY, AND HENCE THAT RIGHT WILL BE ALL YOURS.
AS LONG AS THE RETURN ON DEBT EXCEEDS THE AMOUNT OF INTEREST PAID, THE USE OF DEBT
FINANCING IS ADVANTAGEOUS TO A FIRM. THIS IS BECAUSE INTEREST PAYMENTS ON DEBT ARE
TAX-DEDUCTIBLE.
DEBT LOAD MAKES A FIRM RISKIER (SINCE DEBT MUST BE PAID
REGARDLESS OF WHETHER THE COMPANY IS PROFITABLE
Equity
Equity is the permanent capital of an enterprise, contributed by the firm’s owners in the hopes of earning a
return.
A return on equity is uncertain because equity embodies only a residual interest in the firm’s assets (residual
because it is the claim left over after all debt has been satisfied).
Periodic returns to owners of excess earnings are referred to as dividends. The firm may be contractually
obligated to pay dividends to preferred stockholders but not to common stockholders.
Equity capital reflects ownership while debt

capital reflects an obligation.
Typically, the cost of equity exceeds the cost of debt. The risk to shareholders
is greater than to lenders since payment on a debt is required by law
regardless of a company's profit margins.
Why is too much equity expensive?
The Cost of Equity is generally higher than the Cost of Debt
since equity investors take on more risk when purchasing a
company’s stock as opposed to a company’s bond.
Therefore, an equity investor will demand higher returns (an
Equity Risk Premium) than the equivalent bond investor to
compensate him/her for the additional risk that he/she is
taking on when purchasing stock. Investing in stocks is
riskier than investing in bonds because of a number of
factors, for example:
The stock market has a higher volatility of returns than the bond market
Stockholders have a lower claim on company assets in case of company default

Capital gains are not a guarantee
Dividends are discretionary (i.e., a company has no legal obligation to issue dividends)
Capital adequacy is a term normally used in connection with financial institutions. A bank must be
able to pay those depositors that demand their money on a given day and still be able to make
new loans. Capital adequacy can be discussed in terms of
Solvency (the ability to pay long-term obligations as they

mature)
Liquidity (the ability to pay for day-to-day ongoing operations)
Reserves (the specific amount a bank must have on hand to pay

depositors)
Capital Structure Ratios - Meaning and Importance
Capital structure ratios report the relative proportions of debt and equity in a firm’s capital structure at a
given reporting date.
Total debt to total

capital ratio
The debt-to-capital ratio is a measurement of a company's
financial leverage.
Measurement of a company's financial leverage, calculated by taking the

company's interest-bearing debt and dividing it by total capital.
All else equal, the higher the debt-to-capital ratio, the riskier the company.
When total debt to total capital is low, it means more of the firm’s capital is
supplied by the stockholders. Thus, creditors prefer this ratio to be low as a
cushion against losses.
Debt to equity ratio
The term “debt to equity ratio” refers to the financial

ratio that compares the capital contributed by the
a low ratio means a
creditors and the capital contributed by the shareholder. lower relative debt
In other words, the ratio captures the relationship burden and thus
between the fraction of the total assets that have been better chances of
repayment of
funded by the creditors and the fraction of the total
creditors.
assets that have been funded by the shareholders.
The long-term debt to equity ratio reports the long-term debt burden carried
by a company per dollar of equity.
A low ratio means a firm will have

an easier time raising new debt
(since its low current debt load
makes it a good credit risk).
The debt to total assets ratio (also called the debt ratio) reports the total debt burden
carried by a company per dollar of assets.
Earnings Coverage Ratios
Ability to generate the

earnings that will allow it to
service debt.
TImes interest earned ratio
The times interest earned ratio is an income
statement approach to evaluating a firm’s
ongoing ability to meet the interest payments
on its debt obligations.
The most accurate calculation of the numerator includes only earnings expected to recur. Consequently, unusual or
infrequent items, discontinued operations, and the effects of accounting changes should be excluded.
Earnings to fixed charges ratio
Fixed charges include interest, required principal repayments, and leases.

This is a more conservative ratio since it measures the coverage of earnings over all fixed charges, not just
interest expense.
Cash flow to fixed charges ratio
The fixed-charge ratio is used by lenders looking to

analyze the amount of cash flow a company has
available for debt repayment. A low ratio often
reveals a lack of ability to make payments on fixed
charges,

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WHAT IS

SOLVENCY IS THE ABILITY OF A COMPANY TO MEET ITS

FOR EXAMPLE, A COMPANY WITH A HIGHER PERCENT OF DEBT CAPITAL WILL BE

Equity capital reflects ownership while debt

Stockholders have a lower claim on company assets in case of company default

Solvency (the ability to pay long-term obligations as they

Liquidity (the ability to pay for day-to-day ongoing operations)

Reserves (the specific amount a bank must have on hand to pay

Total debt to total

Measurement of a company's financial leverage, calculated by taking the

The term “debt to equity ratio” refers to the financial

A low ratio means a firm will have

Ability to generate the

Fixed charges include interest, required principal repayments, and leases.

The fixed-charge ratio is used by lenders looking to

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