Solvency Ratios in Financial Modeling
Solvency ratios indicate the risk inherent in the company as a result of its debt.
A good financial analyst will use solvency ratios to keep tabs of the forecasts made in a financial modeling exercise on debt accumulation to ensure that they are realistic and prudent.
A good financial analyst will also use solvency ratios to assess the debt profile of a company from its financial statements, and analyze whether the company needs to undergo debt restructuring exercises such as mortgage refinancing, debt consolidation, etc.
There are 2 common solvency ratios that a financial analyst is likely to come across when building a financial model.
Leverage ratios
The leverage ratio, or gearing level, effectively measures the fixed debt payment commitment. Too high a gearing level can imply a high risk to the cash flow of a company and its ability to pay dividends to shareholders.
Leverage = Debt / [ Capital employed ( i.e. equity + debt )]
Interest cover
Measures the ability of the company to pay interest out of profits. Most banks would expect the cover to exceed 1.5 times.
Interest cover = Profit before interest and tax / Loan interest expense
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