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Industry Characteristics and their Influence on the Company’s Solvency Evaluation

General info on the company’s solvency evaluation aspects

The main goal of the debtor and creditor relationships is the mutually beneficial partnership, which is directly connected with the debtor’s solvency. An insolvent company wouldn’t be an attractive partner neither for a bank, nor for suppliers and investors.

During the solvency evaluation the special attention should be paid to different parameters. One of them is the company’s industry. The analysis of the current situation in the industry allows to forecast external risks that can influence the profitability of a firm and, moreover, the ability of a firm to meet its obligations. Every economic sector has its unique set of conditions that influence the overall financial result.

The influence of industry conditions on the company’s solvency

While analyzing the solvency of a borrowing company the whole necessary information about its environment, including industry conditions, should be taken into account. For instance, liabilities of industrial enterprises are usually protected with significant fixed assets, which are slow to depreciate. While for trading enterprises the value of goods is variable, which influences the amount of liabilities secured. That’s why in case of the equal debt to equity ratio creditors’ money are more protected in case of their usage by industrial firms.

Overall, solvency analysis of an enterprise should be started from the market analysis and competition evaluation. The market geography is also an important factor, so the borders of the market should be determined (local, regional, national, international, global, etc.). The size of the market has a direct influence on the diversity of consumers, which, in its turn, influences the sustainability of the company’s profitability. Greater consumer diversity brings stable income, and thus, the enterprise is more financially reliable.

During the indicators analysis they should be compared with certain normative values. In their turn, normative values may vary, which makes it more difficult to estimate the solvency of a company. Normative values fluctuations are connected with numerous factors, which can be divided into internal (implementation of new production technologies, etc.) and external (current economic situation, etc.). Below you can find some commonly accepted normative values for some of the financial ratios:

Financial Ratio

Agricultural production

Oil and Gas Extraction

Electric Power Generation, Transmission and Distribution

Construction of Buildings

Miscellaneous Store Retailers

Religious, Grantmaking, Civic and Professional Organizations

Current Ratio

>= 1,4

>= 1,2

>= 0,9

>= 1,6

>= 1,6

>= 2,9

Quick Ratio

>= 0,8

>= 1

>= 0,5

>= 0,7

>= 0,7

>= 2,6

Net Sales to Working Capital

>= 10,7

>= 12,3

-

>= 6,3

>= 9,9

>= 2

Coverage Ratio

>= 2,4

>= 7,5

>= 1,1

>= 9,1

>= 7,8

>= 3,7

Total Assets Turnover

>= 0,9

>= 0,5

>= 0,4

>= 1,7

>= 2,1

>= 0,8

Inventory Turnover

>= 4,7

>= 31,9

>= 21,8

>= 5,3

>= 4,7

>= 40,9

Receivables Turnover

>= 10,3

>= 4,9

>= 6,2

>= 10,4

>= 11,2

>= 12,1

Total Liabilities to Net Worth

<= 2,2

<= 1,2

<= 3,2

<= 2,7

<= 1,8

<= 0,6

Debt Ratio, %

>= 69,2

>= 55,4

>= 76,3

>= 73

>= 63,9

>= 36,6

Return on Total Assets, %

>= 5,8

>= 13,3

>= 3,3

>= 11,8

>= 15

>= 1,6

Return on Equity (After Income Tax), %

>= 8,5

>= 19,3

-

>= 31,9

>= 29,7

>= 1,3

Profit Margin (After Income Tax), %

>= 2,9

>= 18,3

-

>= 4,9

>= 5

>= 1

Source: Almanac of Business and Industrial Financial Ratios

The more indicators will be calculated and estimated according to this table of normative values, the more precise evaluation of the company’s financial condition and solvency will be. Due to the wide range of normative values the analyst should also take into account previous years values for the same indicators.

Depending on the industry, all firms have some specific aspects in their solvency estimation.

Retail and wholesale trading enterprises sell goods bought from other companies. That’s why the most important asset for them is finished goods stock. Thus, during the analysis of trading enterprises a special attention should be paid to the structure and dynamics of this element of assets. In particular, the analyst should estimate the goods stock turnover in times and days, the share of the goods stock in the total amount of assets, etc. and monthly values of the sales turnover level.

The structure of capital resources may vary depending on the selling procedure. In retail chains goods are being bought for cash, that’s why the share of accounts receivable in the total amount of assets is low. For wholesalers commodity loans usually are an important part of the sales promotion policy, that’s why under such conditions the share of accounts receivable will be high. In this case the analyst should pay attention to the quality of the accounts receivable.

Companies working in service and manufacturing spheres have some unique conditions. Although a service is a final product ready for sale, it cannot be kept at the warehouse, and so the share of stocks in the total amount of assets isn’t high. In companies where the intellectual capital plays the key role the share of fixed assets is relatively low (this refers to the companies of educational sector, consumer services, IT, etc.). Analyzing such firms a special attention should be paid to the efficiency of the current assets usage. Conversely, for the manufacturing companies the share of fixed assets, raw materials and unfinished goods in the total amount of assets is high. In this case such indicators as capital turnover, current assets coverage ratio, change of the value of assets in time, and others should be reviewed.

In agriculture the land is the main asset and so it has a big share in the total amount of the farms’ assets. Unlike most kinds of assets the land is not subject to amortization. Also the asset structure might include biological assets. It is important to review the value change of biological assets during the analyzed period.

In the finance sector companies usually have a big share of long-term and short-term investments in securities, estate, etc. in the total amount of their assets. Measurement of such investments’ quality and estimation of the probability of meeting the obligations are very important. Commonly, the structure of assets of such companies includes a big share of the borrowed capital. For instance, for banks this share is usually higher than 90%. That’s why analysis of the cost of the borrowed capital is necessary.

Conclusion

The estimation of the financial condition and solvency of the company is a complex process involving calculation and interpretation of numerous financial indicators. Of course, there are certain universal financial indicators, which should necessarily be reviewed, regardless of the industry the company refers to. They are liquidity, financial sustainability, profitability, activity indicators, etc. However, for more precise estimation, the values should be compared within certain industries, in which analyzed companies operate.

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