Transcription Doc

Determining Solvency and Liquidity

Note: This transcription document is a text version of the upGrad videos present in this session.
It is not meant to be read independently but can be used to complement your video watching
experience.

Video 1

Speaker: Prof. Simona Scarparo

There are many ways to assess the performance of a company. To determine the solvency and
liquidity of a company we use ratio analysis.
Remember how earlier we had used Cost-Volume-Profit analysis to determine the viability of a
company.
Ratio analysis uses information from the three financial statements – profit and loss, balance sheet
and cash flow statement to gain insights into different areas of the organisation. While there are
many different areas of ratio analysis, we will be focusing on solvency and liquidity analysis for now.
Ratio analysis is useful to gain a snapshot of an organisation at a particular time and also to determine
how the business is performing over time. It can also be used to compare one company with another
from the same industry. This is known as benchmarking.
Ratio analysis is a quick and simple way to evaluate the health of an organisation. It is generally used
by accounting, management as well as investors as all of the information is provided in the company’s
financial reports.
Ratio analysis can be very useful in providing you with key indicators of the performance of the
business over time. You can use ratio analysis to discover some of the strengths and weaknesses of
the company. They are very important metrics used in developing a strategic plan.
A ratio is simply one quantity compared with another. Mathematically it is expressed as A:B.
Here is a basic example.

For example, the ratio of 5 to 2 means that for every 5 units of A there are 2 units of B.
Some examples of ratios analysed in accounting include:
1. Inventory turnover (Shows how efficient a company is with their inventory)
2. Return on assets (Shows how efficient a company is at earning profits from their assets), and
3. Debt to equity (Shows the relationship between the debt financing and equity financing of
the company)

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It should be noted that in ratio analysis, the information provided is an indicator. In many cases, by
itself the information only provides a partial picture of the company. It is often necessary to analyse
ratios together.
More importantly the result from a ratio tells you that there is something to investigate. Ratio analysis
is no substitute for an executive’s ability to actually investigate the company to determine the cause
of a particular result. When we looked at Netflix in the previous section, we could see a declining
liquidity with an improving solvency. We did not have sufficient information to determine the cause
or strategy at play. What it did point out is a discrepancy; the cause of the results must be
investigated.
Ratios are a good way to determine the relationship between two quantities.
In accounting we use ratios in a very precise way. A ratio is represented as A:B.
Take for example the debt-to-equity ratio. When comparing Debt (A) to Equity (B) the ratio is defined
by:

Ratio = A / B.
The formular for the debt-to-equity formular is quite simple:
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
For a fictitious company with total liabilities of USD 5 billion and total equity of USD 2 billion:
𝑈𝑆𝐷5 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
𝐷𝑒𝑏𝑡 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
𝑈𝑆𝐷2 𝑏𝑖𝑙𝑙𝑖𝑜𝑛
Debt to equity ratio = 2.5
What this figure tells us is that the Total Liabilities is 2.5 times greater than the Total Equity.
Throughout this session we will be utilising ratios in this manner to see how one quantity relates to
another quantity, specifically as it relates to Solvency and Liquidity.

Video 2

Speaker: Vikram Kulkarni

To understand ratio analysis, let us see some of the key metrics between three companies namely
Infosys, Tata Consultancy Services and Mindtree. All three companies are part of India’s IT Sector.
TCS and Infosys are the biggest entities in this sector while Mindtree is a smaller company as
compared to the other two. This comparison will give us an idea about how benchmarking happens
and how does these numbers make sense regarding the financial position of the companies.

Here in this sheet, three ratios are calculated for all the three firms. These ratios are namely net profit
margin, receivables as a percentage of revenue and receivables turnover.

First, let us consider the net profit margin. Here, you can see that the bigger the size of the company,
the higher the revenue is. Based on the analysis, we can also assume that once a company grows in

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size, it can reduce costs and have pricing power as well. And Because of this, the firms generating
higher revenue have higher profit margins.

Next, let us consider receivables as a percentage of revenue. Here, across the three companies, you
can see that all three companies have similar receivables at approximately twenty per cent (20%) of
their respective revenues. So, we can infer that size does not matter here and this is kind of a norm
for the sector.

Now, let’s consider and analyse receivables turnover. This ratio means how many days of credit
period is given by the companies to the clients. As we can see, it is approximately 70 days for the
three companies. In this case as well, the size of the company does not matter. This also points to
the inference that this is the norm for receivables turnover for the sector. However, if the days are
much higher or much less than 70 for any company, then questions need to be asked why that is
happening. So, these are the examples of a few ratios and how benchmarking is done. More ratios
will follow in subsequent sections.

Video 3

Speaker: Prof. Simona Scarparo

Previously we discussed a company’s liquidity, its ability to pay its short-term liabilities.
Liquidity analysis is used to answer questions such as:
- Does the company have enough cash to repay the loan tomorrow?
- Will the company have enough cash in 2 months to pay its pension obligations? And
- Will the company be able to pay for its inventory that is due in 90 days?

In fact, liquidity analysis can be used to assess the short-term risk of a business. These ratios give
executives the information necessary to make short-term decisions. In the next section, when we
discuss solvency ratios, we will look at how those ratios give information necessary to make long-
term decisions.
There are two major liquidity ratios that we will look at in this section:
1. Current ratio, and
2. Quick ratio

Each of these ratios provides slightly different information about the liquidity of the company and
you will find them more useful if you calculate both of them rather than looking at one in isolation.
As previously discussed, calculating these ratios without taking into account the industry, the size of
the company and geographical locations can provide meaningless information.
We will review each of these rations in turn in this section.

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 Video 4

Speaker:

In the previous section we covered the two key liquidity ratios. In this section we will turn our
attention to long term health of the company.

Solvency is defined as the ability of a company to pay its long-term liabilities. A company that is
solvent has more assets than it has liabilities. In other words, assets minus liabilities equals a
positive value as well as a manageable debt load.

While liquidity is used to assess short term risk, solvency is used to assess long term risk. Lenders
often use solvency ratios to determine the likelihood of a company defaulting on its loans. There
are three major solvency ratios that we will discuss in this section.

1. Debt to Equity ratio

2. Debt to Assets ratio, and
3. Interest Coverage ratio
Each of these ratios provides slightly different information about the solvency of the company. You
will find them more useful if you calculate all three rather than looking at one in isolation.

A few key points should be considered while assessing solvency. Both liquidity and solvency ratios
should be viewed together to get a full picture of the company’s ability to meet its obligations. And
as with liquidity, it is often necessary to use benchmarking to determine the significance of
particular results. Now we will take a look at Solvency ratios.

Video 4

Speaker: Vikram Kulkarni

Now, let us understand the various ratio calculations using the financial statements. We will consider
Infosys as an example here to calculate the liquidity and solvency ratios.

For your convenience, we have summarised the financial statements of Infosys. Based on this table,
the current assets of Infosys were worth fifty thousand and seventeen (50,017) crores for the
financial year 2018, which increased to fifty-two thousand eight hundred and seventy-eight (52,878)
crores in 2019 and further increased to fifty-four thousand five hundred and seventy-six (54,576)
crores in 2020. The current liabilities for the firm also follow a similar pattern; they were worth
fourteen thousand one hundred and five (14,105) crores in the financial year 2018 and increased to

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eighteen thousand six hundred and thirty-eight (18,638) crores and twenty thousand eight hundred
fifty-six (20,856) crores in subsequent financial years respectively.

Now, we will calculate the liquidity ratios based on the given information. First, let’s calculate the
current ratio. It can be obtained by dividing the total current assets of the firm by the total current
liabilities. Using this formula, we get the current ratios as 3.54, 2.83 and 2.61 for the three financial
years respectively. As we can see, the current ratio for the firm is decreasing despite the increase in
its current assets. This is because the current liabilities are growing at a relatively faster rate than the
current assets.

Now, let us calculate the quick ratio for Infosys for the financial years. Quick ratio is used to measure
a company’s ability to meet its short-term liabilities by using its most liquid assets. So, to calculate
this, we will use the most liquid assets like cash, cash equivalents, short-term investments and
accounts receivable instead of the net current assets which involve less liquid assets as well.

To obtain the quick ratio, we must add up all the most liquid assets and divide them by the current
liabilities for the given year. Using this formula, we get the quick ratios as 2.79, 2.20 and 2.01 for the
three financial years respectively. Why did the quick ratio decrease? This is because the cash and
cash equivalents and short-term investments have decreased in this year as compared to previous
years. Also, the current liabilities are increasing year-on-year. Is this a bad sign for the company? Not
necessarily. It may indicate that the company is not holding on to their liquid assets and taking some
calculated decisions with respect to business like expansion and acquisitions in the last three years.

Now that we have calculated the liquidity ratios, let’s move on to the solvency ratios. Again, for your
convenience, we have summarised the financial statements of Infosys to reflect only the necessary
information. As we can see from the table, the total liabilities of Infosys are increasing year-on-year.
But the total assets of the firm are increasing by a similar amount as well. As a result of this, the total
equity of the firm remains almost constant. The earnings before interest and taxes (EBIT) are also
increasing slightly year on year. However, the interest pay-outs are very different for each year.

Now, let us calculate the solvency ratios based on the given information. First, let’s calculate the
debt-to-equity ratio. It can be obtained by dividing the total liabilities of the firm by its total equity.
Using this formula, we get the debt-to-equity ratios for Infosys as 0.23, 0.30 and 0.41 for the three
financial years respectively. The ratios suggest that the company is not taking too much debt as
compared to their shareholder’s equity. A rising value of debt-to-equity ratio over years would have
indicated that Infosys is increasing their debt financing but that’s not the case here. Next is debt to
assets ratio. It can be obtained by dividing the total liabilities of the firm by its total assets. Using this
formula, we get the debt to assets ratios for Infosys as 0.19, 0.23 and 0.29 respectively or the three
financial years. Since the ratios are way less than 1, we can infer that Infosys has not used debt as a
key source to finance their assets. This also indicates that Infosys is very solvent and is able to cover
their long-term obligations.

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Next, let’s calculate the interest coverage ratios for Infosys. It can be obtained by dividing the
earnings before interest and taxes (EBIT) of the firm by its Interest expenses for the year. Using this
formula, we get the interest coverage ratios for Infosys as 170 and 130 for financial years 2018 and
2020 respectively. For the year 2019, the net interest expense for Infosys is zero. Hence, the interest
coverage ratio will not make any sense. The ratios indicate that Infosys is in a good enough position
to cover their interest expenses on the debt they have taken.

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