How to: Rating assessment, the solvency ratios
The credit rating measures the economic and financial balance of a company. The entity is analyzed from different perspectives, in order to assess its creditworthiness or its ability to generate resources to meet its debts.
It is therefore not the single data to be evaluated, but the overall financial management of the company.
MORE (Multi Objective Rating Evaluation), the Rating methodology in s-peek, is based on the same principles, evaluating the company in terms of solvency, liquidity and profitability. Each area receives a score based on the values of the balance ratios, and the weight of each coefficient on the result of the final rating is determined by an algorithm that takes into account several variables, including the sector and the country in which it operates.
To finance its assets and activities, a company can tap into internal or external sources; the solvency ratios notes the use of funds, divided into risk capital (as known as equity capital, the entity’s owned capital, invested by the entrepreneur herself or by the shareholders), and loan capital (as known as borrowed capital, external investments by banks, funds, trusts, etc.).
Resorting to borrowed capital means contracting debts. Funding sources’ management must therefore be balanced; optimally, equity capital should be larger than borrowed capital. Solvency indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities.
Mainly used to highlight the proportion of funding sources, total leverage measures the total debt of the company and can be calculated by comparing the total liability to equity (total assets - equity / equity): if the result is equal to 1, the sources are equally distributed between equity and liabilities, if it is greater than 1 external sources prevail over internal ones.
Results between 0 and 2 show an adequate sources’ proportion, while values above 3 indicate a strong imbalance.
In addition to total leverage, a financial leverage is also included in the assessment of the solvency ratio, indicating the total financial debt of the company (total financial debt / equity): the higher the value, the higher the debt.
Assessing the MORE Credit Rating, the solvency ratio will be more or less influencing depending on the sector and the country the entity operates in. Statistically Italian companies tend to be undercapitalized, and so the solvency ratio has a greater weight compared to companies operating in other countries.
Therefore, if we want to improve or keep our company's rating high, we should limit (wherever possible) the debt and better balance the funds.