External financial non-dependency score (excluding commercial liabilities)
This score measures the level of a company's external financing (debt with third parties) relative to its total assets. This relationship is called financial leverage.
How to use the score
A low external financial non-dependency score (excluding commercial liabilities) indicates a high level of external funding. The company is using external resources (bank loans, syndicated loans, securitized debt, etc.) to finance its activity. On the other hand, a high score indicates that the company is mainly using its own assets (resources contributed by partners and retained earnings) to finance its activity.
The following table can be used as a reference for the use of this score:
| Score value range | Interpretation |
|---|---|
| 0 to 5 | High level of external funding |
| 5 to 7 | Low level of external funding |
| 7 to 10 | No external funding |
About the financial leverage
The level of external financing (financial leverage) directly influences two of a company's main accounting variables: financial profitability and solvency. The effect of leverage on these two variables is opposite: increasing one decreases the other.
Increase in leverage
All else being equal, increasing financial leverage will increase financial profitability and decrease solvency (as long as the financing cost is less than the company's economic profitability).
An increase in financial leverage means a higher level of external financing; that is, we are financing the activity with increasing borrowed resources. Since shareholders contribute fewer resources to finance the company's activity, their financial profitability increases because the same profit is generated (ceteris paribus) with less equity.
But this higher level of external financing and profitability is offset by lower solvency (both static and dynamic), since increased leverage implies a higher level of debt and higher interest expenses.
Decrease in leverage
On the other hand, a decrease in financial leverage will imply, ceteris paribus, (1) a reduction in financial profitability (provided the cost of financing is less than the company's economic profitability) and (2) an increase in the company's solvency, both static and dynamic.
Example analysis
Consider two companies, both with the same solvency and equity profitability scores. Company A has a low external financial non-dependency score, while company B has a high score. Which is a better investment?
If there are no changes in the economic or financial conditions, both companies are equally attractive from an investor's point of view, since they have the same scores for profitability and solvency.
However, any change in economic or financial conditions will affect the more leveraged company, A, more significantly than company B. For example, an increase in interest rates will primarily affect A, causing an increase in its interest expenses and reducing both its profitability and solvency. Company B will be largely unaffected by this change. On the other hand, the less-leveraged company B has significant room to increase its financial profitability by increasing its financial leverage, as long as this does not significantly affect its solvency. The more-leveraged company A lacks this flexibility.
Conversely, if the solvency levels of both companies were very low, company B would have room to increase its solvency by reducing its leverage.
Therefore, in general, a high score indicates that the company has, ceteris paribus, room to increase its financial profitability, while a low score indicates that the company has room to increase its solvency.
Liabilities used in the calculation
In calculating this score, the so-called commercial liability is considered as a source of cyclical external financing. By commercial liabilities we refer to all the indebtedness derived from the acquisition of productive factors necessary for the production and sale of the company's goods and/or services.
An example of a commercial liability would be the financing provided by the suppliers of the company. Suppose, for example, a chain of distribution of foodstuffs, and suppose that the chain finances the acquisition of food from its suppliers by 90 days bills of exchange. This 90 day financing is a commercial liability and is considered as external financing in the calculation of this score.
However, this commercial liability does not pay interest, it will be amortized by the sale of the purchased food, and it is expected to be automatically renewed at 90 days with the purchase of more foodstuffs from the supplier. Therefore we can see how this liability has a different character than the rest of company's liabilities: (1) does not pay interest, (2) is amortized via sales and (3) is renewed automatically in a cyclically manner. So this financing has the same characteristics as the permanent financing of the capital contributed by shareholders.
Due to this similarity between the commercial liability and the company's equity, the external financial non-dependence score (without commercial liabilities) excludes that commercial liability from the calculation of the company's financial leverage.
It will always be true that the value of the score without commercial liabilities will be greater than or equal to the score that considers the commercial liability as financial leverage. Both will coincide when the company does not have any commercial liabilities.