Long-term solvency focuses on a firm’s ability to pay the interest and principal on its long-term debt. There are two commonly used ratios relating to servicing long-term debt. One measures ability to pay interest, the other the ability to repay the principal.
The ratio for interest compares the amount of income available for paying interest with the amount of the interest expense. This ratio is called Interest Coverage or Times Interest Earned.
The amount of income available for paying interest is simply earnings before interest and before income taxes. (Business interest expense is deductible for income tax purposes; therefore, income taxes are based on earnings after interest, otherwise known as earnings before income taxes.)
Earnings before interest and taxes is known as EBIT. The ratio for Interest Coverage or Times Interest Earned is EBIT/Interest Expense. For instance, assume that EBIT is $120,000 and interest expense is $60,000. Then:
Interest Coverage or Times Interest Earned = $120,000/ $60,000 = 2
This shows that the business has EBIT sufficient to cover 2 times its interest expense. The cushion, or margin of safety, is therefore quite substantial.
Whether a given interest coverage ratio is acceptable depends on the industry. Different industries have different degrees of year-to-year fluctuations in EBIT. Interest coverage of 2 times may be satisfactory for a steady and mature firm in an industry with stable earnings, such as regulated gas and electricity supply.
However, when the same industry experiences the uncertain forces of deregulation, earnings may become volatile, and interest coverage of 2 may prove to be inadequate. In more-turbulent industries, such as movie studios and
Internet retailers, an interest coverage of 2 may be regarded as insufficient. The long-term solvency ratio that reflects a firm’s ability to repay principal on long-term debt is the “Debt to Equity” ratio. The long-term capital structure of a firm is made up principally of two types of financing: (1) long-term debt and (2) owner equity.
Some hybrid forms of financing mix characteristics of debt and equity but usually can be classified as mainly debt or equity in nature. Therefore the distinction between debt and equity is normally clear.
If long-term debt is $150,000 and equity is $300,000, then the debt equity relationship is usually measured as:
Debt to Equity Ratio = Long-Term Debt/Long-Term Debt Equity = 33.33%
Long-term debt is frequently secured by liens on property and has priority on payment of periodic interest and repayment of principal. There is no priority for equity, however, for dividend payments or return of capital to owners.
Holders of long-term debt thus have a high degree of security in receiving full and punctual payments of interest and principal. But, in good times or bad, whether income is high or low, long-term creditors are entitled to receive no more than these fixed amounts. They have reduced their risk of gain or loss in exchange for more certainty. By contrast, owners of equity enjoy no such certainty.
They are entitled to nothing except dividends, if declared, and, in the case of bankruptcy, whatever funds might be left over after all obligations have been paid. Theirs is a totally at-risk investment. They prosper in good times and suffer in bad times. They accept these risks in the hope that in the long run gains will substantially exceed losses.
From the firm’s point of view, long-term debt obligations are a burden that must be carried whether income is low, absent, or even negative. But long term debt obligations are a blessing when income is lush since they receive no more than their fixed payments, even if incomes soar.
The greater the proportion of long-term debt and smaller the proportion of equity in the capital structure, the more the incomes of the equity holders will fluctuate according to how good or bad times are. The proportion of long-term debt to equity is known as leverage.
The greater the proportion of long-term debt to equity, the more leveraged the firm is considered to be. The more leveraged the firm is, the more equity holders prosper in good times and the worse they fare in bad times.
Because increased leverage leads to increased volatility of incomes, increased leverage is regarded as an indicator of increased risk, though a moderate degree of leverage is thus considered desirable. The debt-to equity ratio is evaluated according to industry standards and each industry’s customary volatility of earnings.
For example, a debt-to-equity ratio of 80% would be considered conservative in banking (where leverage is customarily above 80% and earnings are relatively stable) but would be regarded as extremely risky for toy manufacturing or designer apparel (where earnings are more volatile). The well-known junk bonds are an example of long-term debt securities where leverage is considered too high in relation to earnings volatility.
The increased risk associated with junk bonds explains their higher interest yields. This illustrates the general financial principle that the greater the risk, the higher the expected return.
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