Category: Credit Rating Methodologies

Solvency analysis of a company

I am back once again on how to analyze the creditworthiness of a company. We have had in-depth analysis of liquidity a few weeks ago (link) but in that article we’ve exactly said that “the solvency is always the main element of one company’s financial analysis” ; so today we talk about solvency.

The concept is extremely simple: a company is solvent when it can pay back its debts especially if we look at the medium / long term. So who is insolvent? Who has a few debts to repay. But what does “a few” mean? We’ll see it in this article.

If you look at the books, many are pointing the attention mainly on financial debts and how these, in order to be evaluated, must be compared with other balance sheet items. We will see in this article that just looking at the financial debts is not enough, and especially a check of the values ​​taken by the ratio sometimes is not enough but it requires the intervention of a real analyst to understand the nature of debts and even more.

To help us, we’ve taken the 2012 financial accounts of “ENERGY ACEA SPA” , Acea Group company, that deals with the sale of electricity, gas and value-added services. Let’s evaluate the debt ratio of this company with two classical ratios:

• EBITDA / Net Financial Position = € 33.6 million / (NFP negative) = Infinity

• Financial Debt / Equity = € 0/ € 12.4 million = 0

So now, we have the situation of a company that not only has no financial debts but also has a little cash (€ 12,000) which gives a Net Financial Position (NFP) of € -12,000.

Is it a company with a good solvency? I would say no.

In fact, if we go to see all the liabilities we note that there is a VERY consistent ” trade payables” item which amounts to € 314.5 million; also the remaining debts, not financial ones, are high enough to bring the calculation of the Leverage (calculated as Shareholders’ Equity / Total liabilities ) to a very high value :

• Leverage = Shareholders’ Equity / Total Debt = 55.66

If you do realize that in the sector of ACEA , this value is around 2 , you see that the volume of non-financial debt is very high and this means that objectively there is a solvency problem.

Beware, however, that the analysis cannot be conducted only in numbers , there must also be a qualitative analysis of debt. You have to pay attention mainly to the following things:

1. Companies belonging to groups often have high amounts of receivables and payables to other group companies or to the parent company: in this case you must also check the solvency of the group;

2. Not paying suppliers enables them to borrow at no cost ( whereas the banks absolutely get their money’s worth), this policy is followed mainly by SMEs and more when they already have liquidity problems or try to find funding.

3. The Shareholders’ Equity represents a value which, in extreme cases, is the ability to repay the debts of the company. Generally, it consists of Capital and Profits carried forward from previous years . But if this is not the case, I would urge you to analyze the nature of the other items that might be , depending on the laws of the country , even revaluations of property, funds due to amnesties or other funds whose are not always equivalent to actual availability of funds usable to cover debts.

The case of DANONE SPA, an Italian company belonging to DANONE Group, is also interesting. It is well capitalized presenting a leverage (as per 2012 data) of only 0.57 with a net worth of over 488 million euro. If we look at the composition of the item, it would seem to arouse suspicion since the main part of the equity belongs to “other reserves”:

In fact, investigating better, it turns out that the “other reserves ” are the real money due to previous acquisitions made ​​by Danone and extraordinary reserves destined, in addition to paying dividends, also to a capital increase:

The lessons taken from this story are:

1. Always look at the debt (financial and non-financial) compared to shareholders’ equity;

2. Always investigate the nature of the shareholders’ equity.

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