Solvency Ratios

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Solvency RatioDescriptionWhen to UseExampleFormula
Debt-to-Equity RatioMeasures the proportion of a company’s debt to its equity.Evaluate the financial risk and leverage.A debt-to-equity ratio of 0.5 suggests moderate leverage.Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity
Times Interest Earned (TIE)Measures a company’s ability to cover interest payments with its earnings before interest and taxes.Assess solvency and ability to meet interest obligations.A TIE ratio of 4 indicates earnings are four times the interest expenses.TIE = Earnings Before Interest and Taxes (EBIT) / Interest Expense
Debt RatioCompares a company’s total debt to its total assets.Assess the proportion of assets financed by debt.A debt ratio of 0.4 indicates 40% of assets are financed by debt.Debt Ratio = Total Debt / Total Assets
Financial Leverage RatioMeasures the proportion of a company’s assets that are financed with debt.Evaluate the extent of financial leverage.A financial leverage ratio of 0.6 indicates 60% of assets are financed with debt.Financial Leverage Ratio = Total Assets / Shareholders’ Equity
Debt-Service Coverage Ratio (DSCR)Measures a company’s ability to meet its debt obligations by comparing its operating income to its debt payments.Assess the ability to service debt.A DSCR of 2 suggests operating income is twice the debt payments.DSCR = Operating Income / Total Debt Service
Interest Coverage RatioMeasures a company’s ability to cover interest expenses with its operating income.Assess the ability to meet interest obligations.An interest coverage ratio of 3 suggests operating income is three times interest expenses.Interest Coverage Ratio = Operating Income / Interest Expense
Current Debt RatioCompares a company’s current liabilities to its total debt.Evaluate the proportion of short-term debt.A current debt ratio of 0.3 suggests 30% of total debt is short-term.Current Debt Ratio = Current Liabilities / Total Debt
Long-Term Debt RatioCompares a company’s long-term debt to its total debt.Assess the proportion of long-term debt.A long-term debt ratio of 0.7 suggests 70% of total debt is long-term.Long-Term Debt Ratio = Long-Term Debt / Total Debt
Debt-Equity Swap RatioMeasures the ratio of debt that can be converted into equity to the total equity.Assess the potential impact of convertible debt on equity.A swap ratio of 0.2 means 20% of debt can be converted into equity.Debt-Equity Swap Ratio = Convertible Debt / Total Equity
Debt Coverage Ratio (DCR)Measures the ability to meet all debt obligations, including interest and principal payments.Assess the ability to cover all debt-related payments.A DCR of 1.2 indicates sufficient cash flow to cover all debt obligations.DCR = Cash Flow from Operations / Total Debt Service
Equity RatioCompares a company’s total equity to its total assets.Assess the proportion of assets financed by equity.An equity ratio of 0.6 suggests 60% of assets are financed by equity.Equity Ratio = Shareholders’ Equity / Total Assets
Debt Ratio (to Equity)Measures the relationship between a company’s debt and equity as a ratio.Evaluate the balance between debt and equity financing.A debt ratio of 1.2 indicates 1.2 times more debt than equity.Debt Ratio (to Equity) = Total Debt / Shareholders’ Equity
Debt-Asset RatioMeasures the proportion of a company’s assets that are financed by debt.Assess the risk associated with asset-backed debt.A debt-asset ratio of 0.4 indicates 40% of assets are debt-financed.Debt-Asset Ratio = Total Debt / Total Assets
Equity MultiplierMeasures the extent to which a company uses leverage to finance its assets.Evaluate the impact of debt on total assets.An equity multiplier of 2 suggests assets are financed twice as much as equity.Equity Multiplier = Total Assets / Shareholders’ Equity
Debt Capacity RatioMeasures a company’s ability to take on additional debt while maintaining its current financial ratios.Assess capacity for further debt financing.A debt capacity ratio of 0.5 indicates 50% capacity for additional debt.Debt Capacity Ratio = Debt Capacity / Existing Debt
Debt to Capital RatioMeasures the proportion of a company’s capital structure that is debt.Assess the balance between debt and equity in the capital structure.A debt to capital ratio of 0.4 suggests 40% of the capital structure is debt.Debt to Capital Ratio = Total Debt / (Total Debt + Shareholders’ Equity)
Total Debt to Total Assets RatioMeasures the proportion of total assets that are financed by debt.Assess the risk associated with debt financing.A total debt to total assets ratio of 0.3 indicates 30% of assets are debt-financed.Total Debt to Total Assets Ratio = Total Debt / Total Assets
Fixed Charge Coverage RatioMeasures a company’s ability to cover all fixed charges (interest, lease payments, etc.) with its earnings.Assess the ability to meet fixed financial obligations.A fixed charge coverage ratio of 3 suggests earnings are three times fixed charges.Fixed Charge Coverage Ratio = (EBIT + Fixed Charges) / Fixed Charges
Debt Growth RateMeasures the annual growth rate of a company’s debt.Assess the rate of debt accumulation.A debt growth rate of 8% indicates debt increased by 8% annually.Debt Growth Rate = (Current Debt – Previous Debt) / Previous Debt
The Enlightened Accountant by Gennaro Cuofano – FourWeekMBADownload

Connected Financial Concepts

Circle of Competence

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The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

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Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

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The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

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Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

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Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

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Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

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Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

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Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

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Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

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Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

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Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

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The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

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The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

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Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

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Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

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Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

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Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

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WACC

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The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

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A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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