The financial stability of a company is its ability to carry out its operating activities over a certain period of time. In contrast to solvency, which characterizes the company’s ability to repay its liabilities from its assets, financial stability is a broader characteristic. To some extent, it can be argued that an organization’s solvency is one of the components of its financial stability.
Financial stability of a company is evaluated on the basis of two groups of indicators:
- Capital structure indicators.
- Debt load indicators.
These indicators are essential for any business. Owners should know them not only if they have a huge business like the best online casino NZ or Netflix but also if they have a small startup in the most unusual niche with just a few employees.
Some of the following ratios are calculated using the indicators of the statement of financial position, also known as the balance sheet. Balance sheet indicators are recommended to be calculated on an annual average basis, rather than on a specific date, for a more accurate calculation of financial strength indicators.
The generally accepted method consists of four main stages, namely:
- Setting the goals of the analysis and the approaches used.
- Evaluating the quality of the information to be used in the analysis.
- Choosing methods.
- Conducting the analysis and processing the results.
The first stage is setting the goals of the analysis of the financial stability of the organization, as well as choosing the approach to be used. The following approaches are possible.
- Comparing the calculated values of the organization’s indicators with normative values in the industry.
- comparing the values of indicators for the current reporting period with data from previous periods.
- Comparing the organization’s ratios with the ratios of other companies.
At the second stage the assessment of the quality of the received information is performed. The information used for analysis should meet certain requirements: it should be complete, reliable and objective. Besides, the information obtained should be sufficient for the analysis.
At the third stage, the best method for assessing financial stability of the organization is selected.
At the fourth stage, the analysis is performed directly, the results are processed, which are the basis for making decisions on business management, its maintenance and development.
Capital Structure Indicators
Globally, capital structure is the ratio of equity to debt capital, measured in various ways through similar ratios. The most common capital structure metrics include the following.
D/E (debt-to-equity ratio)
D/E = Debt / Equity, where
Debt is the company’s financial debt (liabilities on loans and borrowings).
Equity is the company’s assets.
DR (debt ratio)
DR = Debt / (Debt + Equity), where
Debt is the company’s financial debt (liabilities on credits and loans).
Equity is the company’s assets.
The coefficient of financial leverage and the coefficient of financial dependence are identical indicators showing the ratio of debt and equity in the company’s capital structure. The permissible values of these ratios differ significantly from industry to industry, due to which the analysis of these indicators for an individual organization should be conducted either in dynamics or in comparison with average industry values. The range of normal values of the D/E ratio depending on the industry is between 0.2 and 1.5.
A D/E ratio that is higher than the norm indicates an excessively high share of debt capital in the organization. In other words, a company with higher ratios in this group belongs more to creditors than to shareholders. On the contrary, an excessively low D/E ratio indicates that the company does not make full use of the possibility to attract more funds for business development.
CR (capitalization ratio)
CR = LTL / (LTL + Equity), where
LTL are long-term liabilities of the company.
Equity is the company’s assets.
The capitalization ratio is externally similar to the financial leverage ratio, but instead of financial debt, long-term liabilities are used to calculate this indicator. Thus, the capitalization ratio does not take into account short-term debt, but takes into account non-financial long-term liabilities – long-term accounts payable, deferred tax liabilities, etc.
Normative values of this coefficient are not set. That’s why the main analytical value it represents is not stable. When observing steady growth of the capitalization ratio, we can conclude on the growth of long-term liabilities of the company, not supported by the growth of equity, which indicates a latent decrease in the shares of shareholders in the total capital of the organization.
Debt Load Indicators
Debt load ratios show the level of the company’s debt burden. Based on their values, it is possible to understand the extent to which the organization is able to repay its debt out of its profits.
D/EBITDA = Debt / EBITDA, where
Debt is the company’s financial debt (debts on credits and loans).
EBITDA are earnings before interest, taxes, depreciation & amortization.
D/EBITDA shows how effectively the company is able to repay its financial debt from its own profit. To minimize the impact of depreciation policy and tax treatment, EBITDA is used as earnings less depreciation, taxes and interest (which are debt service costs).
The marginal normative value of D/EBITDA is considered to be 3. With higher values of this ratio, one can conclude that the company’s debt burden is growing and, as a consequence, its financial stability is decreasing.
ICR (interest coverage ratio)
ICR = EBIT / Interest expenses, where
EBIT are earnings before interest & taxes.
Interest expenses are interests on loans and borrowings.
This ratio shows a company’s ability to service its debt at the expense of its own profit, i.e. to pay interest. Unlike D/EBITDA, when calculating ICR we usually use EBIT, because depreciation cannot be the basis for interest payments.
The minimum ICR is usually considered to be 1.5. If the ratio is below 1, however, the company can be considered presumptive bankrupt, since it has no nominal basis for interest payments.
It should be remembered that interest is not paid from the accounting profits, but from the funds in the accounts of the firm. There are situations when a nominally unprofitable company is able to fulfill all its debt service obligations at the expense of competent financial management, and cases when a formally profitable company has no money to pay interest.
Financial strength ratios are of interest to both investors and creditors of the company. If a business’s financial strength indicators show a negative trend, it is necessary to take prompt measures to restore the company’s financial strengths. For example, to optimize the debt load or revise the capital structure.