Dynamic solvency score
This solvency score indicates a company's ability to meet its long-term payment commitments (liabilities) from a dynamic point of view. It is an important indicator because an insolvent company is usually forced to stop operating and is liquidated to meet these financial obligations. For this score's calculation, Gradement uses the best existing insolvency prediction model based on a dynamic analysis of the company's activity.
How to use the score
The following table can be used as a reference for this score:
| Score value range | Interpretation |
|---|---|
| 0 to 5 | Company with a tendency towards insolvency |
| 5 to 7 | Company with low probability of insolvency |
| 7 to 10 | Company with very low probability of insolvency |
Difference between solvency and liquidity
Do not confuse solvency and liquidity. Liquidity is a property of a company's assets that indicates their ease of conversion into cash without a significant loss of value.
Solvency, which this score calculates, measures a company's ability to handle its long-term debt. Therefore, non-solvent companies can have liquid assets, and solvent companies can have non-liquid assets. The solvency model Gradement employs uses liquidity as just one of the internal factors to predict insolvency from a static point of view.
Predicting insolvency
The usual method of solvency analysis, the patrimonialist model, is used by most analysts. It is based on a relatively simplistic comparison between a company's current assets and liabilities (the acid test). This model considers a company solvent if it has enough assets to pay all its liabilities. We consider this model overly simplistic because the ultimate goal of solvency analysis should be to determine if the company can remain in the market and continue operating under current conditions. Clearly, this objective can hardly be reached if the company has to sell its assets to remain solvent.
Gradement uses a much more sophisticated model to calculate this score, based on an analysis of both the company's balance sheet and cash generation. This model analyzes whether:
- The balance sheet structure allows the company to generate enough surplus funds to maintain a stable structure. This is the so-called static solvency analysis. The model is based on adjusting the company's balance sheet accounts to analyze imbalances and detect aggregate account structures tending toward insolvency.
- The company can generate sufficient funds on a regular and permanent basis to meet all financial obligations of the accounting period. This is the so-called dynamic solvency analysis.
The Dynamic solvency score captures the tendency toward insolvency by analyzing if the funds generated in the corresponding accounting period can meet all liabilities payable during that period (point 2).