External financial non-dependency score (ex commercial liabilities)
This score is a measure of the level of external financing (debt with third parties), currently held by the company, in relation to its total assets. This relationship is called financial leverage.
How to use the score
A low external financial non-dependency score (ex commercial liabilities) value will indicate a low level of external funding. The company is using its own assets to finance its activity (resources contributed by partners and resources generated by the company in past years and not distributed to partners). On the other hand, a high value of this score will indicate that the company is mainly using other people's resources (bank loans, syndicated loans, securitized debt, financing of suppliers, etc.) to finance its activity.
The following table can be used as a reference for the use of this score:
| Score value range | Interpretation |
|---|---|
| from 0 to 5 | High level of external funding |
| from 5 to 7 | Low level of external funding |
| from 7 to 10 | No external funding |
About the financial leverage
The level of external financing (financial leverage) has a direct influence on two of the main accounting variables of every company: financial profitability and solvency. The effect of the variation of the leverage in both variables is the opposite: increasing one make the other decrease.
Increase in leverage
All things being equal, increasing the level of financial leverage will increase the financial profitability and decrease the solvency (as long as the financing cost is less than the company's economic profitability.
An increase in the financial leverage means a higher level of external financing, that is, we are financing the activity with increasing borrowed resources. As the shareholders have to contribute less resources to finance the company's activity, their financial profitability increases because the same profit (ceteris paribus) but contributing less equity.
But this higher level of external financing and profitability is offset by a lower solvency, both static and dynamic, since the increase in leverage implies a higher level of debt with third parties and higher expenses on the financial interest paid.
Decrease in leverage
On the other hand, the decrease in financial leverage will imply, ceteris paribus (1) a reduction in financial profitability (provided that the cost of financing is less than the economic profitability of the company) and (2) an increase in solvency of the company, both static and dynamic.
Example analysis
Consider two companies, both with the same value in their solvency and equity profitability scores, but one of them (company A) presents a low level of external financial independence score, while the other (company B) has a high value of this score. Which of them is best from the point of view of an investor?
If there are no changes in the economic and/or financial conditions of both companies both of them are equally attractive from the investor point of view since the two of them have the same score values in the main categories of profitability and solvency.
However, any change in the economic and/or financial conditions will significantly affect the more leveraged company A, more than to the B company. For example, an increase in interest rates will mainly affect A as raising interest rates will cause an increase in its interest expenses and will reduce both its profitability and its solvency. The B company will not be affected by this change. On the other hand, the less leveraged B company has significant margin to increase its financial profitability if necessary by increasing its level of financial leverage, as long as this increase does not significantly affect its solvency level. The A company, more leveraged, lacks this margin.
On the other hand, if the solvency levels of both companies were very small, the B company would have room to increase its solvency by reducing its level of leverage.
Therefore, in general, a high level of this score indicates that the company has , ceteris paribus margin to increase its financial profitability, while a low level of this score indicates that the company has room to increase its solvency level.
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.