LONG-TERM SOLVENCY DEFINITION BASIC INFORMATION AND TUTORIALS

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.

SHORT TERM LIQUIDITY DEFINITION BASIC INFORMATION AND TUTORIALS

In the emergency room the first question is: Can this patient survive? Similarly, the first issue in analyzing financial statements is: Can this company survive?

Business survival means being able to pay the bills, meet the payroll, and come up with the rent. In other words, is there enough liquidity to provide the cash needed to pay current financial commitments? “Yes” means survival. “No” means bankruptcy.

The urgency of this question is why current assets (which are expected to turn into cash within a year) and current liabilities (which are expected to be paid in cash within a year) are shown separately on the balance sheet. Net current assets (current assets less current liabilities) is known as working capital.

Because most businesses cannot operate without positive working capital, the question of whether current assets exceed current liabilities is crucial.

When current assets are greater than current liabilities, there is sufficient liquidity to enable the enterprise to survive. However, when current liabilities exceed current assets the enterprise may well be in immanent danger of bankruptcy.

The financial ratio used to measure this risk is current assets divided by current liabilities, and is known as the current ratio. It is expressed as “2.5 to 1” or “2.5 1” or just “2.5.” Keeping the current ratio from dropping below 1 is the bare minimum to indicate survival, but it lacks any margin of safety.

A company must maintain a reasonable margin of safety, or cushion, because the current ratio, like all financial ratios, is only a rough approximation. For this reason, in most cases a current ratio of 2 or more just begins to provide credible evidence of liquidity.

LIQUIDITY RISK BASIC DEFINITION AND TUTORIALS

LIQUIDITY RISK BASIC INFORMATION
What Is Liquidity Risk?


Liquidity risk is the uncertainty introduced by the secondary market for an investment. When an investor acquires an asset, he or she expects that the investment will mature (as with a bond) or that it will be salable to someone else.

In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments.

The more difficult it is to make this conversion, the greater the liquidity risk. An investor must consider two questions when assessing the liquidity risk of an investment:

(1) How long will it take to convert the investment into cash?

(2) How certain is the price to be received?

Similar uncertainty faces an investor who wants to acquire an asset: How long will it take to acquire the asset? How uncertain is the price to be paid?

Uncertainty regarding how fast an investment can be bought or sold, or the existence of uncertainty about its price, increases liquidity risk. A U.S. government Treasury bill has almost no liquidity risk because it can be bought or sold in minutes at a price almost identical to the quoted price.

In contrast, examples of illiquid investments include a work of art, an antique, or a parcel of real estate in a remote area. For such investments, it may require a long time to find a buyer and the selling prices could vary substantially from expectations.

Investors will increase their required rates of return to compensate for liquidity risk. Liquidity risk can be a significant consideration when investing in foreign securities depending on the country and the liquidity of its stock and bond markets.