5.3 Solvency ratios

Another key area of financial statement analysis is an evaluation of how the business entity is financed in the long run. Investors and lenders are most interested in an analysis of the solvency of a company. The solvency ratios, including gearing or leverage ratios, analyse the overall capital structure of the company and compare long-term debt (loans) of a company either with its equity or assets. It is worthwhile noting that:

• Debt is generally cheaper than shareholders’ funds given the different levels of risk taken by each finance provider. Debt financing makes it easier for management to estimate total fixed obligations and plan a fixed repayment schedule. The interest paid for servicing debt is a tax-deductible expense and results in lower tax obligations. Debt financing is also attractive for shareholders when they want to raise finance without diluting the shareholding structure of the company. However, debt brings with it the requirement to make interest payments and principal repayments at set times. It is a significant regular cash commitment for the organisation.
• Shareholders’ funds require a greater return to compensate for the greater risk carried, linked to the subordinate status they have compared to debt if the firm is liquidated. However, they carry no obligation to provide returns at a set time. The return expected by equity holders can be provided, at least in part, by capital growth (i.e. share price rises for quoted companies), which does not require the immediate flow of cash out of the business.

In consequence, the greater the variability in performance, arguably the more the requirement for long-term finance should be met through shareholders’ funds rather than debt: that is, the riskier the business, the greater the dependence on shareholders’ funds rather than debt. Access to equity markets, however, may be a realistic option only for fairly large companies with established records. Small and medium companies have to rely on debt when entrepreneurs have no additional finance to invest in the venture. Otherwise, the company has to constrain its growth. Public sector organisations, by their very nature, do not have access to private equity.

The purpose of solvency ratios is to evaluate how much of the business’s assets are owned by shareholders and lenders. More specifically, a focus is placed on the relationship between debt financing and equity financing. If a company’s assets are owned mostly by its shareholders, then the company is said to be less leveraged and the level of risk associated with meeting long-term debt obligations is considered low. On the other hand, a company where most of the assets are financed by long-term debt is considered to have high leverage with a higher level of risk.