 Hello and welcome to the session in which we would look at solvency ratios. This topic is part of the financial statement analysis, part five of seven. In part one we looked at the introduction of financial statement analysis and part two we looked at horizontal, vertical and common size. In part three we looked at the liquidity ratios and part four we looked at activity ratios and in this part, part five we look at the solvency ratios. The solvency ratios are similar in concept to the liquidity ratios except they measure the ability of the company to pay off its long term debt. So on the long term, can you pay off your long term debt? Can you survive long enough? Do you have enough ability to survive long enough? Can you handle additional borrowing? This is what the solvency ratios are measuring. There are a few ratios we're going to look at and it's going to be the same concept. We're going to go to the balance, we're going to go to the excel sheet and look at the figures, compute the numbers and try to make sense of them. Once again we are looking at this balance sheet and income statement and this balance sheet can be found on farhatlectures.com. So let's take a look at our solvency ratios and try to make more sense of them. Let's take a look at the first one which is called the debt ratio and it's computed by taking total liabilities divided by total debt. Now to understand the debt ratios or the solvency ratios, it's very important to understand the concept, the basic concept accounting equation which is assets equal to liabilities plus equity. So let me show you what does that mean. If you have $100 in assets, 40% is that, 60% must be equity. So assets equal to $40 in liabilities plus 60% in equity. Now the debt ratios show you the proportion of your assets that are financed by debt. How much of your assets financed by debt? For example, this example here, we have 40 out of the $100 is financed by debt. It means the debt to equity ratio, debt to asset ratio is 40%. Well, is this good? Is this bad? Well, here's what we can say about the equity, about the debt ratio. The higher the debt ratio, the higher the proportion of your assets financed by debt. What does that mean? It means more debt and this theme is going to reoccur again and again in this session. The more debt you have, the riskier you are as a company. The lower is the flexibility. It means you cannot borrow additional money if needed because you're already maxed out or close to maxed out. In some companies, they might have, for example, a ratio of 80 or 90%. For example, airline companies, most of their assets are financed through debt. Their airplanes are leased, which is a form of debt. It means if we have a lot of debt, it means we are relying less on equity. So let's assume in this example, we change this to 80% liabilities in 20% equity. Now it's 80%. It means 80% of your assets are financed through debt. Now, for the company that we have, we can take a look at the last two years and see what's happening here. Just to get an idea. If we take total assets divided by total liabilities for year one, it's 0.54. It means for every dollar we have an asset, 54 pennies are coming from liabilities from debt. Now, is this reasonable? As an auditor, you have to ask yourself, is this what we expect in this industry? Is this what we expect from prior years? So the auditor will always come with an expectation. And if the expectation is to have 0.4, then something happened. There somehow they're having a lot of debt. If the expectation is 0.7 and what we're seeing here is 0.54, then we have to question this. Are they hiding any debt? What happened? Did they pay off the debt? And if so, how did they were able to pay off the debt? Or are they hiding? Is there any debt that's off the balance sheet that we can't see anymore? But if we compare those two companies from year to year, it's pretty stable. And that's the good thing about ratios. When you have multiple years, there should be some sort of a relationship between the years. So if it's stable and if there's no reason for those ratios to change, then any change will draw attention. It means take a look at this. It might be a red flag, need further investigation. The equity ratio, kind of similar to the debt ratios, and you're going to see they complement each other, is total liabilities divided by total equity. If we remember this example, when we started, we said 100 and assets, $40 finance through debt. It means the remaining through equity. So if we take 60 divided by 100, our equity ratio is 60%. Again, what does that mean? It means 60% of our assets are financed through equity. Now, bear in mind equity could be retained earnings. Equity could be common stock. Equity could be preferred stock, so on and so forth. But the point is 60% coming from equity. Well, do we like to have more equity or more debt? Depending on your risk tolerance, if you are a risky company, if you like risk, you will take more on debt. That means more risk. Why? Because debt, you have to pay the interest rate, whether you are doing good or not. And that's why debt is risky. When you rely more on equity, the equity holders are willing to wait if the company is not making profit because they're the company themselves, so you're under no pressure. So that's why higher equity ratio means more flexibility for the company because if an opportunity comes and you need to borrow money, now you have less debt relative to your asset. Maybe lenders, maybe bankers can lend you the money. And notice here, if we look at this company for year one, it's 0.46. And notice it's no coincidence that if we add 0.54 plus 0.46, it gives us 100%. It means this company, the one that we are working with, 54% of it is financed through that, 46% of it is financed through equity. And notice in year two, we relied less on that. We went down 2% on that. And we relied more on equity. And that 2% went to equity. So it's very important to understand this. And debt to equity and equity ratio should be pretty straightforward. At least I hope you understand them. Before I proceed, I would like to remind you whether you are a student or a CPA candidate. You take a look at my website, farhatlectures.com. I don't replace your CPA review course. I don't replace your accounting course. I'm a useful addition to your accounting education, to your CPA exam. My motto is saving accounting students and CPA candidate one at a time. Invest in yourself. This is a list of my course catalog where I have lectures, multiple choice, true, false, about intermediate accounting, advanced accounting, governmental accounting, basic accounting, managerial, so on and so forth. My CPA material is aligned with your Roger, Wiley, Becker, Gleam, so on and so forth. So it's very easy to go back and forth between my material and your CPA review course. I also give you access to all previously AI CPA released questions. And that's 1,500 of them with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording, share it with others. Connect with me on Instagram, Facebook, Twitter and Reddit. I'm going to go from the equity ratio to the equity multiplier. And if you notice, all what we did with the equity ratio and the equity multiplier is we flipped the numerator and the denominator. What does that equity multiplier means? How do we interpret this? So let's start with an equity multiplier. Let's assume we have a company with $100 in assets equal to zero liabilities plus 100 in equity. It means this company is 100% finance and equity. So if we compute the equity multiplier, we'll take 100 divided by 100 equal to 1. Well, what does 1 mean? 1 means everything is coming from the equity shareholders. Because to find what's coming from the debt, we'll take the 1 minus. We always subtract 1. It means the other part of the company and it's going to give us 0. So let's use some numbers. Let's assume we have $100 in asset. And let's assume for the sake of illustration, 75 is coming from equity from debt and 25 from equity. Assets equal 75 of liabilities, 25 debt. Now, let's compute the equity multiplier. It's going to be 100 divided by 25. And that's going to give us 4. What does 4 means? Well, 4 means for every time, if you want to look at it from a dollar perspective, for every dollars we raise, if we subtract 1, 3 coming from debt. So for example, if we raise $4, if we have $4, 3 coming from debt, 1 coming from equity. And the higher this number, and the higher this number, the more leverage we are. So let's assume we have $100. Let me just go to the extreme, $90 from debt plus $10 in equity. Now, 100 divided by 10 equal to 10. It means every time we have $10 to work with, $9 is coming from, oh, I do subtract 1 to come to the debt portion, $9 is coming from debt and $1 is coming from equity. Now we are really, really highly leveraged. It means basically we control, like the owners have practically not zero risk. They're taking a lot of risk, but they're not risking their money. Yes, there's a lot of risk in running a company with a lot of debt. But who's going to carry the bag if in case anything went bad? The debt holders, they invested most of the money. The company is highly leveraged. So this is what the equity multiplier is. The higher it is, the riskier is the company. It means we are relying on that. Now, if we go back here and look at debt to equity ratio, it shows us the structure. Basically, again, if we go back to 100 equal to 75 using this 75 and 25. And what we do is we, if we take 75 liabilities divided by 25 of equity, we got 3. And what did I tell you? It tells us how much the debtors are bringing to the company. All we have to do is notice, 217 minus 1 equal to 117. For this company, what's going to happen? For every $2.17, the debt holders are bringing $1.17. For the 4, when we had the equity multiplier 4 for every dollars minus 1, the debt to equity will be 3. That means for every dollar we bring in equity, the debt holders are bringing 3 to make that $4. So 3 from the creditors, one from the equity holders. And the more you bring from the debtors, the riskier is the company. But again, the higher is the return for the equity holder. Now, why are we talking about all of this? Well, again, from an auditor's perspective, if there is anything unusual, if the company can't highly leverage, this is important for the auditor. High leverage means high risk. High risk means more pressure on the company to fudge the numbers. So the higher that risk, so if you see these numbers, if you see debt ratios is increasing, if you see the equity multiplier is increasing, well, the company is coming under financial pressure. You have to pay a little bit more attention to that company. The time's interest earned is basically computing, taking income before interest and taxes and be careful income before interest and taxes divided by the interest expense. Let's start with some simple numbers. Let's assume our income before interest and taxes is 10, our interest expense is two, the answer is five. How do we interpret this number five? It means our income, our earnings, before we pay interest and taxes can cover our interest expense five times. Now, generally speaking, we want this number from a investor's perspective, creditors perspective, especially creditors perspective, also investor because you have to pay the creditors first. We want to be this as high as possible. This is basically a degree of protection. The higher, the better. So if you only had $1 in interest expense and you have earnings before interest and taxes of 10, then this is equal to 10, it's higher. The higher, the more protection. Again, how do you use this? If this number, you would have an expectation walking into the audit that this should be seven. You computed the number at 7.98. Well, it's a little bit higher than seven, but it is within seven. But if the answer was six or the answer was five, then they have less protection. We need to know what's going on. Just FYI, or if the answer was 10 for this company rather than 7.98, what's happening? Are they reducing their interest expense and increasing their income? Are they playing with the figures? So on and so forth. Now, the good thing about interest expense, it's easy to compute why? Because as long as you know how much that the company has, you can estimate the interest expense because based on the loan balances and the interest, you could compute interest expense. And you would compare interest expense to income before interest and taxes to come up with some figures. And hopefully that figure is close enough to what the company is starting with. Again, you're gonna audit everything. But at the beginning, if something is out of unusual and unusually abnormal, then you can focus on it. It seems here that's between eight and nine their times interest earned. If this has been the trend for the past five, six years, then it means that's what they're trying to keep. If this is not what the trend, you need to understand why. So those are the solvency ratios. What should you do now? Work multiple choice questions. Go to Farhad Lectures, subscribe, work multiple choice questions, download the Excel sheet and play with it. See how the numbers are working. So just change the total asset to see how the equity multiplier will work and see how debt to equity ratio will work. Good luck, study hard. And if you're studying for your CPA exam, it's worth it.