Work out coverage and solvency ratios and explain what they mean

CFA® Level I · Financial Statement Analysis · Financial Analysis Techniques · FSA.5.d

The idea

Solvency ratios measure the ability to meet long-term obligations. Debt to equity and debt to capital describe the structure of the balance sheet; interest coverage, earnings before interest and tax over interest expense, describes the ability to service it from earnings. Coverage is usually the more informative because it relates the obligation to the cash flow that must meet it, while a structural ratio compares two stock figures whose measurement bases may be decades apart. Both are distorted where material obligations sit outside reported debt, which is why commitments and guarantees in the notes are read alongside.

Formulas

Interest coverage

interest coverage = EBIT ÷ interest payments

EBIT: earnings before interest and tax
interest payments: the interest due in the period

How many times over the company can pay its interest out of operating profit. A solvency measure that uses the income statement rather than the balance sheet, which is why it is quoted alongside debt-to-equity rather than instead of it.

Debt-to-equity

debt-to-equity = total debt ÷ total shareholders' equity

total debt: interest-bearing debt, short and long term
total shareholders' equity: book equity, including retained earnings

Book values on both sides, which is the limitation: a company whose shares trade far above book looks more leveraged here than it is. Definitions of debt differ between sources, so two published figures for the same company often disagree.

A practice question

From the question bank, with the reason each wrong option is wrong.

How is interest coverage calculated?

Earnings before interest and tax divided by interest expense — correct
Total debt divided by equityWhy not: That is debt to equity, a structural ratio built from two balance sheet figures. Coverage needs an earnings figure to speak to serviceability.
Operating cash flow divided by total debtWhy not: A legitimate solvency measure in its own right, but it compares cash with principal rather than earnings with the interest bill.

It asks how many times over the period's operating earnings could meet the interest bill, which is the most direct test of serviceability.

A harder one

Earnings before interest and tax are 480 and interest expense 96. What is interest coverage?

4.0 timesWhy not: (480 − 96) ÷ 96 — interest deducted from the numerator first. Coverage uses earnings *before* interest, since that is the pool available to pay it.
5.0 times — correct
6.0 timesWhy not: (480 + 96) ÷ 96 — interest added back to a figure it had never been taken out of. EBIT is already before interest.

480 ÷ 96 = 5.0, so earnings could fall by four fifths before interest went uncovered.

The hardest tier

Why can both solvency ratios understate a company's true obligations?

Because equity is measured at market valueWhy not: Book equity is what the ratios use, and it is not market value. If anything an old company's book equity understates what shareholders have.
Because interest expense excludes capitalised interestWhy not: Capitalised interest is a real omission from the expense line and worth knowing about, but it affects the coverage calculation rather than the size of the obligations themselves.
Because note-only obligations are excluded — correct

Guarantees, purchase commitments and similar exposures are often disclosed in the notes rather than included in reported debt, so ratios built on the balance sheet can understate the total obligation. Reported debt is a starting point: a company guaranteeing an affiliate's borrowings can carry real exposure that its debt figure does not show.

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