Credit Rating Calculation: Unveiling the Process with S-peek - Solvency

How is solvency evaluated?

"Oh, how nice! They awarded us a high rating."
"What? I wonder how this company's rating was determined."
"Just BB? Despite its substantial turnover?"

We're sure you've also had similar thoughts before. And they are completely valid. It's common to feel skeptical when faced with an evaluation of business performanceHowever, it is important to understand that a credit rating assessment is not a mysterious calculation, but rather a careful evaluation of the factors that affect a company's financial balance.

Understanding which indices are considered in the analysis and what information they provide about a company's performance offers at least two major advantages:

  •  It allows the company to self-analyze its health and take action on the most critical factors. 
  • It provides an objective and independent assessment of the reliability of customers and partners, enabling necessary measures to avoid financial losses. 

In the following articles, we will discuss what aspects s-peek considers when calculating a company's rating. We will detail the indices used by the MORE algorithm to evaluate three macro-areas that determine a company's health: liquidity, profitability, and solvency. We will start with solvency and examine how the indices are calculated, particularly Leverage and Financial Leverage. At the end of the article, you will be able to calculate each indicator yourself and compare your result with the one indicated by s-peek in the risk analysis within the Extended12m reports.

How Solvency is Calculated 

When it comes to financing its assets and activities, a company can tap into two types of financing sources: equity capital and third-party capital. Equity capital is the capital invested by the entrepreneur or the company's shareholders, while third-party capital includes capital contributed by external entities like loans, bonds, and supplies. 

However, resorting to third-party capital means incurring debts. The solvency analysis assesses whether the company's financing sources are balanced and sustainable and whether it can meet its incurred debts. This analysis involves various financial indicators, whose values are compared to the average value of companies in the same sector and country.

Leverage: the debt metric

Understanding a company's indebtedness is crucial when analyzing its financial health. The Leverage Ratio is a fundamental indicator that measures the overall level of debt a company has by relating its total debts (liabilities) to its equity. Excessive debt, if not managed properly, can pose a risk to the company and its investors, leading to financial stress. However, if a company's operations can generate a higher return than the interest rate on its loans, then debt can contribute to fueling growth.

How to calculate Leverage

The formula used on S-peek for calculating leverage is as follows:

Leverage = Total Liabilities / Shareholders Funds. 

A Leverage ratio of 1 indicates that the use of sources is evenly distributed between equity and third-party capital. If the ratio is greater than 1, external sources of capital prevail over internal ones. While results between 0 and 2 generally indicate an adequate proportion of investment sources, values above 3 indicate a strong imbalance.

It's important to note that the Leverage Ratio varies significantly depending on the sector, type of activity, or operating context. For example, manufacturing companies usually have a higher leverage ratio than service sector companies, due to the need to finance significant investments in fixed capital like machinery, real estate, and facilities. However, leverage alone is not enough to determine if a company shows adequate solvency. Another indicator to consider is Financial Leverage.

Financial Leverage: the financial indebtedness indicator

Financial leverage measures a company's financial indebtedness by comparing the financial debts to the company's equity.
On S-peek, you can calculate financial leverage by using the following formula:

Financial Leverage = Long-term debt + Loans / Shareholders Funds

The higher the value of the financial leverage, the greater the reliance of the company on external financing to which the company is obligated, not only for the repayment of capital but also for the payment of passive interest (i.e., the cost of debt).

A very high Financial Leverage can be a cause for concern for investors and creditors, especially if the company cannot generates sufficient cash flow for debt repayment and interest. Therefore, it is useful to check if the company's main activity generate a sufficient cash flow to repay interest on debt. But to do this, we need to move on to the analysis of the company's profitability.

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