Question

HEALTH and SAFETY (PTY) LTD (H&S) is a wholesaler of Personal Protective Equipment. At the Beginning of the year 2020, H&S expanded its retail business by adding over 50 shops in order to meet the demand for protective gear. The following information has been extracted from the comparative financial statements included in the company's 2019 annual report (all amounts are in thousands of Rands):

Dec. 31, 2019

Dec. 31, 2018

Total liabilities

R26 000  

R18 000  

Total shareholders' equity

34 000  

38 000  

Depreciation expense

R 2 000   

R 6 000   

Interest expense

3 400   

3 200   

Income tax expense

12 600   

18 100   

Net income / (profit)

6 000   

15 000   

Net cash provided by (used for) operations

41 000   

(400)  

Total dividends paid

2 000   

12 000   

Cash used to purchase plant assets

32 000   

18 000   

Payments on long-term debt

1 600   

1 800   

1)        Using the information provided above, calculate the following for 2019 and 2018:

            a. Debt-to-equity ratio (at each year-end)                                                (2)

            b. Times interests earned ratio                                                                  (2)

2)        Comment briefly on the company's solvency.                                        (4)

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3)        What other ratios will help you assess the solvency?

Answer 1

Part 1)

The debt-to-equity ratio and times interest earned ratio for each year is calculated as follows:

Debt-to-Equity Ratio

Debt-to-Equity Ratio = Total Debt/Total Equity

Debt-to-Equity Ratio (2019) = 26,000/34,000 = 0.76

Debt-to-Equity Ratio (2018) = 18,000/38,000 = 0.47   

_____

Times Interests Earned Ratio

Times Interest Earned Ratio = EBIT/Interest Expense where EBIT = Net Income + Tax + Interest Expense

Times Interest Earned Ratio (2019) = (6,000 + 12,600 + 3,400)/3,400 = 6.47

Times Interest Earned Ratio (2018) = (15,000 + 18,100 + 3,200)/3,200 = 11.34

_____

Part 2)

Based on the ratios calculated in Part 1), it can be concluded that the company is solvent, that is, it will be able to meet its financial obligations as and when they become due. The company's debt-to-equity ratio for both the years is less than 1 (though it has increased in 2019) which means that the company's use of debt to finance its operations is less as compared to the equity. Inclusion of less debt in the capital structure reduces the financial risk of the company because of less fixed interest cost and loan repayment obligations. Similarly, a higher value of times interest earned ratio indicates that the company's earnings are sufficient enough to pay for its interest expenses (which is a debt related obligation). Therefore, the company's long term financial position can be considered to be sound.

_____

Part 3)

The other ratios that can be used for measuring long-term and short-term solvency by the company are given as follows:

1) Debt Ratio = Total Liabilities/Total Assets [for measuring long-term solvency]

2) Financial Leverage Ratio = Total Assets/Total Equity [for measuring long-term solvency]

3) Current Ratio = Total Current Assets/Total Current Liabilities [for measuring short-term solvency]

4) Quick Ratio = Total Quick Assets/Total Current Liabilities [for measuring short-term solvency]