1. Week 10 FINA321 Abdullah Al Shukaili
Solvency
Week 10
FINA321
Abdullah Al Shukaili

2. Learning objectives
Describe capital structure and its relation to solvency.
Explain financial leverage and its implications for company performance and analysis.
Describe capital structure risk and return and its relevance to financial statement analysis.

3. Basics of solvency
Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations.
One of the most important components of solvency analysis is the composition of a company’s capital structure.
Capital structure refers to a company’s sources of financing and its economic attributes.

4. Basics of solvency Analysis of solvency involves:-
Capital structure refers to the sources of financing for a company ( equity and debt capital)
2) Earnings (or earning power)—implying the recurring ability to generate cash from operations

5. Importance of Capital Structure
Capital structure is the equity and debt financing of a company
A company’s financial stability and risk depend on its financing sources and the types and amounts of various assets it owns.

6. Characteristics of Debt and Equity
Equity (or stockholders' equity) refers to the risk capital of a company.
Characteristics of equity capital include its uncertain or unspecified return and its lack of any repayment pattern.
Equity capital contributes to a company’s stability and solvency.

7. Characteristics of Debt and Equity
Unlike equity capital, both short-term and long-term debt capital must be repaid
Still, debt must be repaid at specified times regardless of a company’s financial condition, and so too must periodic interest on most debt
Failure to pay principal and interest typically results in legal proceedings

8. Financial leverage
is the use of debt to increase earnings. Leverage magnifies both managerial success (income) and failure (losses).
Financial leverage refers to the amount of debt financing in a company’s capital structure

9. Capital structure ratios
Total Debt to Total Capital
A comprehensive ratio is available to measure the relation between total debt (Current debt Long-term debt Other liabilities as determined by analysis such as deferred taxes and redeemable preferred) and total capital [Total debt Stockholders’ equity (including preferred)].
The total debt to total capital ratio (also called total debt ratio) is expressed as
Total debt /Total capital
This ratio describes the total debt constituting the total company capital structure.

10. Total Debt to Equity Capital
The total debt to equity capital ratio is defined as: Total debt / Shareholders‘ equity
This ratio implies the total debt ratio from the company’s equity capital

11. Interpretation of Capital Structure Measures
The higher the proportion of debt,
the larger the fixed charges of interest and
higher debt repayment
Capital structure measures serve as screening devices

12. Asset Composition in Solvency Analysis
The assets a company employs in its operating activities determine to some extent the sources of financing
long-term assets are usually financed with equity capital and debt capital
For example: Utilities projects are financed by long term assets

14. Relation of Earnings to Fixed Charges
long-term earnings are the major source of liquidity, solvency, and borrowing capacity.
Earnings coverage measures focus on the relation between debt-related fixed charges and a company’s earnings available to meet these charges.
These measures are important factors in debt ratings

15. Earnings to fixed charges ratio
Earnings available for fixed charges / Fixed charges

16. Fixed Charges
Interest Incurred: is the most direct and obvious fixed charge arising from debt.
We can approximate the amount of interest incurred by referring to the mandatory disclosure of interest paid in the statement of cash flows

17. Times Interest Earned Analysis
times interest earned ratio = Income Tax expense Interest expense / Interest expense
OR EBIT/I