Solvency analysis takes an important part in financial analysis and mostly is used by creditors. Creditors of the business (bondholders, banks that provide loans) don’t care much if company’s profit will skyrocket or keep stable; all they do care is to get lent money back including predetermined interests. Creditors normally do not get any profit share and all they want is to be sure that their money are safe and will be repaid in time and will earn stable yield. And financial analysis used by creditors is different because main goal of their financial analysis is to predict the probability of the insolvency.
Solvency of the company depends on many factors and some of them depend on the management while others not. The most important factor is company’s capital structure. If company is using a lot of debt capital then risk increases. The higher is credit risk of the company the higher is the probability of the insolvency.
Leverage of the company is directly related to company’s solvency and credit risk. The higher is the leverage the higher is insolvency risk of the company. There are two types of leverage:
Despite all the range of factors that can be controlled by the management, there are also environmental factors that cannot be affected by the company. The highest impact can be made by economical environment which forms the demand for company’s products or services but other factors as competition, law environment, technological evolvements and other can have significant importance too. If environment of the industry changes dramatically in to the bad side, many companies in the industry may have solvency problems. However, those companies, that will be most financially healthy from the inside, will survive. There are many ratios that are used to measure if company is healthy in accordance to its capital structure:
- Debt to equity
- Debt to asset ratio
- Debt to EBITDA
- EBITDA coverage ratio
- Interest coverage ratio
- Cash flow coverage ratio
- Cash debt coverage ratio
- Other coverage ratios
All those ratios are important for solvency analysis and should be calculated and compared to similar companies that are doing business in the same sector. The changes in the financial markets (interest rates, debt margins) may have serious impact to company’s ability repay its debts.