Question

Question 3

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) ​
3)        What other ratios will help you assess the solvency?             What information will they provide that you do not already have             concerning the company's solvency?                                                      (2)

Answer 1

Solvency ratios are also known as leverage ratios. It is believed that if a company has a low solvency ratio, it is more at the risk of not being able to fulfil its debt obligation and is likely to default in debt repayment.

Solvency ratios are used by prospective business lenders to determine the solvency state of a business. Companies that have a higher solvency ratio are deemed more likely to meet the debt obligations while companies with a lower solvency ratio are more likely to pose risk for the banks and creditors.

Answer to q-1).

Ratios	Formula	December,31-2019 ( Workings)
Debt to equity ratio	Total Debt / Shareholder’s Equity	= 26000/34000
0.76
Time interest earned ratio	Earnigs before interest and taxes /Interest Expense	=(6000+12600+3400)/3400
6.47

Answer to q-2)

Comment on Company solvency.

On analysis of debt equity ratio - A good debt to equity ratio is around 1 to 1.5. However, the ideal debt to equity ratio will vary depending on the industry because some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.

Here the company is having Debt Equity ratio of 0.76, which is very at standard norms hence the funds are not much financed by debt. The company is managed well, the outside liabilities are comparitively less

On analysis of Times interests earned ratio - the target or the standard ratio is 2.5. If it is over and above 2.5, it is called as acceptable risk. In the HEALTH and SAFETY (PTY) LTD, it is about 6.47 as its is higher than standard. A high ratio means that a company is able to meet its interest obligations because earnings are significantly greater than annual interest obligations. A lower times interest earned ratio means fewer earnings are available to meet interest payments. Thus the company have sufficeient income to meet interest payments.

Hence on the basis of given data, Company performance is good and can concentrate on the growth further.

Answer to q-3). These ratios can help to access solvency

Types of Solvency Ratios

1. Debt to equity ratio

Debt to equity is one of the most used debt solvency ratios. It is also represented as D/E ratio. Debt to equity ratio is calculated by dividing a company’s total liabilities with the shareholder’s equity. These values are obtained from the balance sheet of the company’s financial statements.

It is an important metric which is used to evaluate a company’s financial leverage. This ratio helps understand if the shareholders equity has the ability to cover all the debts in case business is experiencing a rough time.

Formula:-

Debt to equity ratio = total debt / total shareholder’s equity

Or

Debt to equity ratio = total liabilities / total shareholders’ equity

A high debt-to-equity ratio is associated with a higher risk for the business as it indicates that the company is using debt for fuelling its growth. It also indicates lower solvency of the business.

2. Debt to Capital Ratio

Debt to capital ratio is a financial ratio that is used in measuring a company’s financial leverage. It is calculated by taking the total liabilities and dividing it by total capital. If the debt to capital ratio is higher it represents the company is riskier.

The long-term debts include bank loans, bonds payable, notes payable etc.

Formula:-

Debt-To-Capital Ratio = Total Debts / Total Capital

Low debt to capital ratio is indicative of a business that is stable while a higher ratio casts doubt about a firm’s long-term stability. Trading on equity is possible with a higher ratio of debt to capital which helps generate more income for the shareholders of the company.

3. Total Debt to Total Asset Ratio

Total debt to total asset ratio is a type of debt ratio that defines the total amount of debt to the total assets that are owned by a company. This ratio helps reflect the financial stability of the company. A high ratio indicates high degree of leverage and therefore a high risk for the investors looking to invest in the company.

It shows what part of the assets are financed by debt and what part is financed by equity. Investors use this ratio for whether the company has funds for meeting its current debt obligations and determine whether the company is able to pay a return on the investment done.

Formula:-

Total Debt/Total Assets Ratio = Short-Term Debt + Long-Term Debt / Total Assets

Creditors make use of this ratio to determine the debt that company has and if additional debts can be provided to the firm.

Coverage Solvency Ratios

1. Interest Coverage Ratio

The interest coverage ratio is used to determine whether the company is able to pay interest on the outstanding debt obligations

Formula:-

Interest coverage ratio = EBIT / interest payments due on debt

2. Fixed Charge Coverage Ratio or FCCR

This ratio determines a firm’s ability in paying all the fixed charges which can include equipment lease expense, debt payments and interest expense.

Formula:-

Fixed charge coverage ratio = EBIT + fixed charges before tax / interest + fixed charges before tax

Infomration about total assets available, total debts, long term and short term debts etc.. are not available.