Financial risk ratios, also known as solvency ratios, are used to determine the long-term financial health of a business by analysing whether a company carries too much debt. And these ratios can come in very handy when looking to invest or review financial situations.
The solvency ratio is a key metric that can be used to measure whether a company has sufficient cash flow to meet its long-term commitments. The ratio offers a comprehensive measure of solvency, as it factors in depreciation to measure cash flow capacity in relation to all liabilities, such as accounts payable, capital lease and pension plan obligations.
In short, a solvent company’s assets are greater than its liabilities, so it owns more than it owes. Whereas, a company with a low solvency ratio will have less chance of being able to meet its obligations. A liquidity ratio, on the other hand, measures a company’s ability to meet its short-term liabilities, such as paying all creditors and any debt that is due in the following 12 months.
Another important calculation is debt ratio, also known as gearing, which is a solvency ratio that measures a company’s total liabilities, as a percentage of its total assets. Basically, the debt ratio shows how many assets a company would need to sell in order to be able to pay off all of its liabilities. This ratio measures the financial leverage of a company, so a company that has more liabilities than assets would be considered to be highly leveraged and, thus, more risky for lenders.
The debt ratio determines the proportion of a company’s assets that are financed through debt. For example, a debt ratio of more than 0.5 means that more than half of the company’s assets are financed through debt. Whereas, a debt ratio of less than 0.5 means that most of the company’s assets are financed through capital. By calculating this ratio, investors and creditors can analyse an overall debt burden, as well as a company’s ability to pay off debt.
Reading ratios
There are several ratios that can be used to measure strength and sustainability. When reading ratios, it is important to bear in mind the following:
Look at the big financial picture Use several sets of ratios to get a complete understanding of a company’s financial health. For example, when analysing the potential of a company to pay back its external debt, its liquidity should be measured, as well as its solvency. Making any assessment based on just one set of ratios can provide a misleading view of a company’s finances.
Ratios vary from industry to industry, and scheme to scheme Ensure that you make fair comparisons, and don’t compare apples to oranges. It’s only meaningful to compare financial ratios if companies are part of the same industry.
A solvency framework should also promote growth in an industry while ensuring healthy competition amongst different schemes. For example, while it is important for financial stability to be maintained by medical schemes in South Africa, it is also important to bear in mind that there isn’t necessarily a one-size-fits-all solution, so individual circumstances need to be considered.
Evaluate trends By analysing ratio trends over a period of time, you will be able to see if a company’s situation is getting better or worse. By doing this, you will gain a deeper understanding of whether any negative ratios are a result of a one-off event or indicate a serious issue with the company’s fundamentals.
South Africa
Likewise, when analysing the potential of a country to service and pay back its external debt, its solvency and its liquidity are two big issues to be considered. However, as ratios can be affected by varying factors, and a country arguably can’t be treated in exactly the same way as a big company, there is some controversy as to how both of these should be measured.
That said, the bottom line is that South Africa has a long way to go to improve its status, and the country’s economic outlook remains shaky. Business and consumer sentiment have plummeted, and over ZAR50-billion in revenue deficit has left a gaping hole that urgently needs to be filled. After South Africa was downgraded to junk status, the Finance Ministry has stated that “the 2018 budget will outline decisive and specific policy measures to strengthen the fiscal framework.” However, according to an article published on Biz News, “no matter who is president, Minister of Finance or SARS Commissioner, the national numbers will be the same at the national budget speech on 21 February 2018. A complete disaster! South Africa’s debt-to-GDP ratio will remain above 4%.”
Political instability has certainly taken its toll on the economy, and citizens wait with baited breath to see if the tide will turn under Cyril Ramaphosa. Chief Executive of Nedbank, Mike Brown, was quoted in an article published on CNBC to have said that “the February budget statement is South Africa’s last chance to demonstrate the structural reforms and fiscal consolidation that are required to improve economic growth prospects and prevent Moody’s from also downgrading the local currency debt to below investment grade.”
With the 2018 budget speech around the corner, South Africans are preparing themselves for various tax increases, and emotions are generally running high with regards to some of the potential changes. Tax implementations that have been recently explored include an increase in personal income tax rate and the fuel levy, but the government may well cast the tax net even wider in order to raise additional revenue to mitigate the mind-boggling shortfalls of 2017.
For example, the treasury has already signalled that a sugar tax, referred to as a Health Promotion Levy, will be established from April. The proposed tax will increase the cost of soft drinks by up to 11%, which will not only generate revenue, but aims to bring medium- to long-term health benefits to South Africa. However, it could also come with investment cuts and further retrenchments, and it has been argued that its implementation won’t raise enough money to make a substantial difference.
If you are ever unsure about any investment analyses or tax changes, or how anything affects your personal financial situation, then don’t hesitate to arrange a meeting.