Dynamic solvency score
The value of this solvency score is an indication of the ability of the company to meet its long-term payment commitments (liabilities) from a dynamic point of view. It is an important indicator because usually an insolvent company is forced to stop operating and is liquidated in order to be able to face these financial obligations. Gradement uses for the calculation of this score the best existing model of prediction of insolvency based on a dynamic analysis of the activity of the company.
How to use the score
The following table can serve as reference for the use of this score:
|Score value range||Interpretation|
|from 0 to 5||Company with a tendency towards insolvency|
|from 5 to 7||Company with low probability of insolvency|
|from 7 to 10||Company with very low probability of insolvency|
Difference between solvency and liquidity
Do not confuse the concepts of solvency and liquidity. Liquidity is a property of the assets of the company that indicates its ease of conversion into money without losing significant value in the sale.
Solvency, which is what this score calculates, is a measure of the company's ability to cope with its long-term debt. Therefore, there may be non-solvent companies with liquid assets and solvent companies with non-liquid assets. The solvency model that employs Gradement uses liquidity but only as one of the internal factors used to predict insolvency from the static point of view.
The usual method of solvency analysis, called the patrimonialist model, used by the majority of analysts, is a model based on a relatively simplistic comparison between the current assets and liabilities of the company (so called the acid test). This model considers the company to be solvent whenever it has enough assets to pay all its liabilities. We consider this model, traditionally employed by many analysts, to be relatively simplistic in the sense that the final objective of every solvency analysis should be to establish if the company can remain in the market and can continue operating under the same current conditions. Crearly this solvency objective can hardly be reached if, in order to remain solvent, the company has to sell its assets.
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 structure of the balance sheet is such as to allow the company to generate enough surplus funds to maintain this structure stable. This is the so-called static solvency analysis. The model is based on adjusting the balance sheet accounts of the company in a way that allow us to analyze the imbalances between them and the detection of aggregate accounts structures tending to insolvency.
- The company must be able to generate sufficient funds on a regular and permanent basis to meet all the financial obligations of the accounting period. This is the so-called dynamic solvency analysis.
The Dynamic solvency score is the one that captures the tendency to insolvency of the company by analyzing if the funds generated in the corresponding accounting period meets all the liabilities payable during that period (point 2).