Solvency Ratios - Analysis and Interpretation of Financial Statement, Cost Accounting Video Lecture | Cost Accounting - B Com

hi this is David my nocturnal continuing
with CFA level 1 review financial
statement analysis and specifically
ratio analysis the third video in ratios
I've previously looked at activity
ratios most recently liquidity ratios
where I tried to emphasize a difference
here between liquidity and solvency
liquidities focused on the short-term
typically a question of do we have
enough cash to get through in the
short-term as opposed to these here
ratios solvency which are primarily
focused in the long-term and then are
divided into two broad categories debt
ratios that focus on the balance sheet
and measure the amount of debt capital
relative to equity capital and then
there's some redundancy in these
measures we don't use them all we don't
need them all as opposed to the coverage
ratios that introduce the income
statement and measure the ability of a
company to cover its debt payments okay
so if we take just days a hypothetical
ABC Corp and then just pull out some
aggregated major line line items here or
account balances summary account
balances year in 2010 up and then here
end one year later at 2011 keep in mind
these are year-end point in time account
balances equity reserves total financial
debt liabilities the sum of those being
total assets and so while some
definitions will vary in the CFA what's
important is that total debt is the sum
of interest-bearing short term and long
term debt and so it would not include
equity it would not include other
reserves here this term has a few
definitions but here I'm just defining
it as either a contra asset account or
more likely a liability account that's
not really an explicit source of
financial capital and then other
liabilities okay so the sum of those is
total assets and if that's a little
difficult here I just pull the same
numbers into a stylized balance sheet
and here we know on the left hand side
needs to equal the right hand side or
really more specifically equity is
what's left over after we take assets
and subtract all of the liabilities and
so in this case we can have current
liabilities for example of 6,000 and so
a good example of
this is Accounts Payable now accounts
payable is a source of cash when we look
at the cash flow statement but it's not
an explicit source of funding so it's
not like a bank came in and lended us
the accounts payable amount this is not
it does not get included in total debt
and then reserves be other liabilities
maybe represent some contingent
liabilities or provision set aside not
sources of financial capital with the
explicit sources of financial capital
are the debt and the equity another way
to think about this is this the lenders
and the shareholders coming together and
so what would this primarily is
primarily bonds or loans
okay so we'll keep that in mind as we
look at these first three or four ratios
that a lot in common in the sense that
they're all balance sheet accounts and
then then for these first three its
total debt in the numerator so we have
debt to assets here with the ABC Corp
which would be 3000 divided by the total
assets of the left hand side of the
balance sheet of 17700 giving us a debt
assets of a ratio of 16.9% as is usually
the case difficult to analyze in
isolation so we typically they're
benchmark to peers or really benchmark
to its own history so in this case we
look back and we noticed that that rate
debt to assets ratio has dropped and we
can say that that indicates that the
debt has declined and the solvency has
improved this will be one metric that
just in isolation we'd say the solvency
is improved as the debt to asset ratio
has come down debt to capital notice
again balance sheet on balance sheet
total debt again in the numerator but
this time we're comparing it to capital
and so in the case of ABC Corp it's
3,000 debt and equity of five thousand
five hundred so we're going to take the
three and divide it into eight thousand
five hundred the sum of debt plus equity
and so we get a debt to capital of
thirty five point three and we can
compare that what's the trend well
similarly it's coming down and it
indicates that the debt has declined and
the solvency is improved and then debt
to equity
so this time notice we just have equity
in the denominator and in this case 3000
would go into 5500 and give us a higher
absolute number of fifty point five
fifty four point five but relative to
the previous year it's coming down and
so we can make a similar statement that
the solvency has improved now that's no
accident I said there's redundancy so
this debt-to-equity is redundant with
the debt to capital we don't need them
both there may be a more elegant way to
express it but I just if I take debt to
capital I can use that to solve for debt
to equity and you can see here there's a
direct relationship between debt to
equity and debt to capital so they're
redundant we only really need one of
them and just to show that we had a debt
to capital of thirty five point three I
take the reciprocal of that minus one
reciprocal that quantity and I get the
debt to equity okay the last debt ratio
is actually very common so it's the
financial leverage ratio and notice here
we went to average total assets divided
by average total equity remember those
account balances are point in time but
as these most-most both fluctuate assets
and equity over the year might make more
sense to take an average of these
accounts so we have average total equity
divided by average total assets and in
this case we would get a financial
leverage ratio of three point five four
so we just want to keep in mind that
it's okay to express this leverages
equity of our assets but assets over
equity means that the higher is the
ratio the more leveraged is the company
or we could rephrase here every one
dollar of equity is supported by 3.54
cents of assets and then in terms of the
coverage ratio interest coverage ratio
measures how easily a firm can pay its
interest expense so we have EBIT divided
by interest payments earnings before
interest in tax divided by the company's
interest payments and for example if a
bid is 2000 and the interest payments
are 3000 we have an interest coverage of
6.67 and this indicates the company's
now in a better position to pay down its
debt as it's an improvement from the
interest coverage ratio of
for more a bit in order to cover the
interest payments and then finally as
this interest coverage ratio may not
fully reflect the fixed charges
primarily because there are may be
operating leases that are not capital
leases and therefore won't be
capitalized on the balance sheet we can
look at the fixed charge which attempts
to be more comprehensive and adds the
lease payment into both the numerator
and the denominator but it otherwise is
similar so we have EBIT plus the lease
payments divided by interest plus the
lease payments give us a fixed coverage
charge of 3.43 and so arguably we are
more precise about the total fixed
charges because we've now accounted
we've now treated the operating leases
as fixed charges and but directionally
we get the same result in the sense that
the fixed charge ratio has improved and
so there's it indicates a greater
ability to service debt from the
operating earnings and so then here just
a summary of some of these ratios that
we've come over that we've reviewed and
keep in mind these are all solvency
ratios and then we had here these first
four were debt ratios focused on the
balance sheet and these second two are
coverage ratios which invoke are
involved the income statement this is
david the bike chart all thanks for your
time