Accounting: The Language of Business - Vol. 2 (Intermediate: Part 86)

You'll see all other mortal sinners, the ones who flout the honor owed to gods or guests, or loving parents--you'll see them get the justice they deserve. For Hades holds men mightily to a strict accounting down below the earth; he sees all things, inscribes them within the book of his remembering.

Aeschylus

Statements of Financial Position and Cash Flows and the Annual Report (Part W)

by

Charles Lamson

Solvency

Solvency measures a company's ability to meet it's long-term obligations as they come due. A company can finance its operations with debt or equity. When a company decides to use debt, it has to repay the amount borrowed and generally make periodic interest payments. Both creditors, and investors need to assess the company's ability to pay off its long-term obligations when due. Creditors are concerned about timely repayment, investors are interested in sharing profits and securing assets in liquidation as the residual claimants. Firms must pay principal and interest on debt before equity investors share in firm profits. If a company has too much debt, there is a risk that the firm will not be able to repay its debt and be forced to declare bankruptcy.

Two common measures of solvency:

1. Debt-to-equity ratio

2. Interest coverage 

Debt-to-Equity Ratio

Leverage is an indicator of the relative size of financing from creditors versus financing from owners. The debt-to-equity ratio is a measure of leverage computed as:

Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity      (6B.3)

A company with high debt must devote significant resources to making interest and principal payments. When operations are strong and the economy is growing, a company is generally able to make its debt payments. However, if sales decline or an economic recession occurs, the company may struggle to make debt payments. Generally, a high debt-to-equity ratio indicates lower solvency and a greater risk of default. 

Interest Coverage Ratio

The interest coverage ratio measures a company's ability to make payments on, or service, its debt by computing the amount of interest payments it can make from its operating earnings. This ratio is also called the times interest earned ratio. Operating earnings are earnings before interest expense and tax expense. Operating earnings are also known as earnings before interest and taxes or EBIT. Adding both interest expense and tax expense back to net income provides a measure of income that is available to service debt. The interest coverage ratio equation is:

The ratio indicates how many times a company can cover its interest charges before taxes. A high interest coverage ratio indicates that a company is able to service its debt---that is, the company has high solvency. 

EXAMPLE 6B.2 Solvency Analysis of Johnson & Johnson Company, 2016 and 2015

PROBLEM: Using the following information from Johnson & Johnson's 2016 annual report, compute the debt-to-equity ratio and interest coverage ratio for 2015 and 2016. What does each measure indicate about Johnson & Johnson’s solvency?

SOLUTION: The table below provides the computations of Johnson & Johnson's debt to equity ratio and interest coverage ratio for 2016 and 2015.

Johnson & Johnson's debt to equity ratio of 0.893 in 2015 is below 1, indicating that the company obtains more of its financing from shareholders than from creditors. In 2016, its debt-to-equity ratio is 1.005 indicating that the company obtains more of its financing from creditors than from the shareholders. The ratio has increased from 2015 to 2016, implying a decrease in solvency.

The interest coverage ratio, which is 32.006 in 2015 and 28.122 in 2016, is higher than 1, indicating that Johnson & Johnson is able to service its debt from current operations. However, the ratio has decreased from 2015 to 2016, also suggesting a decrease in solvency. 

Overall, this ratio analysis suggests that Johnson & Johnson is in a strong position to meet its long-term obligations.

EXHIBIT 6B.1 summarizes the liquidity and solvency ratios.

EXHIBIT 6B.1 Liquidity and Solvency Ratios

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 309-311*

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