 Hello, and welcome to the session in which we would look at the solvency ratios. Those ratios addresses the firm long-run ability to meet its obligation. Sometimes they're called the financial leverage. Sometimes they're simply called the leverage ratio. This topic is important on the CPA exam because it covers the company from a long-term perspective. Its ability to pay off is it's debt. Whether you are an accounting student or CPA candidate, especially if you're a CPA candidate, most likely you have a review course. Keep your review course. What I can do is I can be a useful addition. I can explain the material differently. I can help you understand it differently, which in turn help you add 10 to 15 points by helping you understand your CPA review better, which in turn you will do better on the CPA exam itself. Your risk with me is a one month of subscription. That's it. You try me for a month. If you feel I'm helping you, you keep it. If not, you cancel. That's your loss. Your potential gain is passing the exam. And let me tell you something. I have helped hundreds, if not thousands of students pass the exam. Are you willing to take that risk? And if not for anything, take a look at my website to find out how well your university doing for the CPA exam. I do have resources and lectures for other accounting and CPA sections. If you haven't connected with me on LinkedIn, please do so. And take a look at my LinkedIn recommendation, like this recording, share it with other. And please, if it's helping you, it might help others. So share the wealth, connect with me on Instagram, Facebook, Twitter. And please connect with me on. So solvency ratio, we're going to, we're going to look at what they are first. And we're going to look by looking at total debt ratio. Let me just, so long-term solvency. Now we're looking at the company, not from a short-term perspective, but from a long-term perspective. So long-term solvency ratios are intended to address the firm long-term ability to pay its obligation or more generally, its financial leverage. These are called financial leverage ratios or just leverage ratios. So those are a bunch of ratios that's going to tell us, how is the company financing itself? Because when you finance yourself, you don't want to rely on short-term. You want to rely on long-term because short-term, you have to pay them every year. You want to rely on long-term financing that's going to give you more time to get you up and running. Then you can pay off your debt. The first ratio we look at is the total debt ratio. The total debt ratio takes into account all that of all maturities to all creditors. It can be defined in several ways. The easiest way is this. The total debt ratio equal to total assets minus total equity, which is assets minus equity equal to liabilities. So they do this and it ends up to be in the numerator, you have liabilities. Liabilities divided by total asset. And this is going to give us 0.28. What does 0.28 means if we have a debt ratio? An analyst might say that proofrock uses 28% debt. Whether this is high or low, it makes any difference depending on whether the capital structure of the company matter. Okay? A subject that's going to be discussing in chapter 6. So is 0.28 a lot or not a lot of high debt ratio or not a high debt ratio? It depends on your industry, which we'll see later on. Okay? But the higher this ratio, the higher is the leverage. Leverage means what? Leverage means the higher you are relying on debt. And the higher your leverage, the higher the risk. And it all depends on your industry. For example, the airline industry will have a high leverage. A retail industry will have low debt ratio. Okay? So proofrock has 28% in debt for every dollar and asset. So basically, if we look at their balance sheet from $1 perspective, they have $1 an asset. 0.28 is coming from debt. Let's make it $100. If they have $100 in assets, $28 is coming from debt. Obviously then what? 72 is coming from equity. 20 yet, 72. So this is the equity and this is the debt. This is what we're saying. Okay? With this in mind, we can define two useful variation on the total debt ratio, the debt to equity and the equity multiplier. Notice because this is assets, debt or liabilities, then equity. So we could just basically manipulate those figures. So we could also calculate debt to equity. And what's debt to equity? It's taken the debt 0.28 divided by equity, 0.72, or 2.8 divided by 7.2, which is 0.38. So again, here is showing us the capital structure of the company. Or we can calculate something called equity multiplier. Equity multiplier is taken total asset, which is 100 or 1 divided by 0.72 or 7.2, which would give us 1.38. So basically, if we take 1 plus the debt ratio, 1 plus the debt ratio, I'm sorry, debt to equity, 1 plus debt to equity, it's going to equal to the equity multiplier. The fact that the equity multiplier is 1 plus the debt to equity ratio is not a coincidence. Let's kind of show it. Total assets divided by total equity is 1 divided by 0.72, which is, if you really think about it, total assets, total equity plus total debt divided by total equity. So this is why it says 1 plus debt to equity ratio. So if you manipulate the formula, that's why it's 1.38. So basically, those are different things, different calculations of saying the same thing. Okay? The thing to notice here is that giving any of these three ratios, you can immediately calculate the other two, so they all say exactly the same thing. What does that mean? What can we say? The company is mostly relying on equity rather than debt. 72% of their assets are tied up in equity, not in debt, not in debt. Okay? So just we need to kind of expand on this little bit, expand on the liquidity ratios. Frequently, financial analysts are more concerned with the firm long-term debt. Why? Because short-term debt will constantly be changing if you have an account spable, if you have accrued liabilities. They constantly change depending on your operation. Also, a firm's account spable may reflect great practice more than debt management policy. Your account spable, depending on your creditors, what's your relationship with your creditors, not how you borrow money? For those reasons, many what they use, they don't use total liabilities, they only use long-term debt in the numerator. So they take the long-term debt divided by the long-term debt plus equity to find out how much of your assets is financed through debt. Okay? So now what we do is we'll take long-term debt divided by long-term debt plus total equity, and this is called long-term debt ratio. Okay? That's going to give us 0.15, 0.15. It means 15, for every dollar, you're only relying on $15 on long-term debt. Remember, the total debt was what? The total debt was 0.28, okay? But the true debt, the long-term debt is only 0.15, okay? The 3048 and the total long-term and equity section is also called the total capitalization. Capitalization means how you are financing your company. The financial manager will frequently focus on this quantity rather than total assets. So they would look at your total long-term debt plus your equity. They don't, again, they factor out the short-term debt. Also, to complicate matters, different people in different books mean different things by the term debt ratio. Some mean a ratio of total debt, some mean a ratio of long-term debt only. And unfortunately, a substantial number are simply vague about which one they mean. It doesn't matter, all what matter. If you're really using it in the real world, basically, if you're using only the long-term debt, keep using long-term debt. So this way, your ratios are comparable from year to year, from period to period. If your competitor is using long-term debt, you need to use your long-term debt. If you're comparing to someone who's using total debt, then you would use total debt. This is a source of confusion, so we choose to give you two separate names to the two measures. The same problem comes up discussing debt-to-equity ratio. Financial analysts frequently calculate this ratio using only long-term debt. Just keep in mind, as long as you are consistent, it doesn't matter how you calculate those ratios, because you want to have consistency. Another ratio we can use to measure the solvency of the company, which is the long-term ability to survive, is how well we can cover our interests. Another common measure of solvency is something called times-interest-earned, or TIE. Once again, there are several possible definitions, but we will stick to the most traditional. Indeed, there's also a few definitions for this. But for our purposes, to calculate times-interest-earned, we're going to take earnings before interest and taxes divided by interest. And for proof rock, if we'll take EBIT from the income statement divided by interest, that's going to give us, I'm going to say, five times. What does five times mean? It means you have earnings, 4.9, that's why I said five. Your earnings can cover five times your interest. Now, the higher this number, the higher this ratio, the better off you are. It means the more coverage you have for your interests. As the name suggests, this ratio measures how well the company has an interest obligation covered, has its interest obligation covered, and it's often called interest coverage ratio. For proof rock, it's 4.9. The higher, the better. The higher, the better. Another ratio we can use, which is very similar to the times-interest-earned, but now we're going to be using not earnings, we're going to be using mostly kind of figuring out from a cash perspective called the cash coverage. So a problem with times-interest-earned is that it's based on EBIT, which is not really a measure of cash available to pay interest. The reason is we deduct depreciation before we get to EBIT. And remember, depreciation is a non-cash expense. Because interest is definitely a cash. One way to define the cash coverage ratio is to take EBIT, then add depreciation, then divide it by the interest. Now, if we take EBIT plus depreciation, obviously what's going to happen to our interest coverage, it's going to go up. So some uses this formula. The other uses the just EBIT. Just EBIT divided by interest. So it all depends. For example, some companies may not have a large depreciation. So depreciation is not an issue. And some companies might have a large depreciation amount. Then depreciation is an issue when you're calculating the cash coverage. The numerator here is EBIT plus depreciation is often abbreviated as EBIT TD, which is earnings before interest taxes and depreciation. EBITD, it's a basic measure of the firm's ability to generate cash from operation. It's frequently used as a measure of cash flow available to meet financial obligation. There's also, there's a variation of the EBITD. Sometime what you do if you have amortization, and whereas amortization, amortization is similar to depreciation, but it's for intangible asset, you add amortization, because amortization also is not a cash expense, just like depreciation. So those are,