External financial non-dependency score
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 indicates a high level of external funding, meaning the company is highly dependent on other people's resources (bank loans, syndicated loans, securitized debt, supplier financing, etc.) to finance its activity. On the other hand, a high score indicates a low level of external funding, meaning the company is using its own assets to finance its activity (resources contributed by partners and retained earnings).
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, so-called commercial liabilities are considered a source of cyclical external financing. Commercial liabilities refer to all indebtedness derived from acquiring productive factors necessary for producing and selling the company's goods and/or services.
An example of a commercial liability is financing provided by a company's suppliers. For example, suppose a food distribution chain finances its food acquisition from suppliers with 90-day bills of exchange. This 90-day financing is a commercial liability and is considered external financing in this score's calculation.
However, this commercial liability does not accrue interest, is amortized by the sale of the purchased food, and is expected to be renewed automatically every 90 days with the purchase of more food from the supplier. Therefore, this liability has a different character than the rest of the company's liabilities: (1) it does not accrue interest, (2) it is amortized via sales, and (3) it is renewed automatically in a cyclical manner. This financing thus has similar characteristics to the permanent financing of capital contributed by shareholders.
Due to this similarity between commercial liabilities and company equity, the external financial non-dependency score (excluding commercial liabilities) excludes commercial liabilities from the calculation of the company's financial leverage.
The value of the score without commercial liabilities will always be greater than or equal to the score that includes them. The scores will be identical when the company has no commercial liabilities.