Analysis of Alphabet/Google: Dynamic Solvency

Feb 18 · 6 min

TL;DR — Alphabet's fundamentals are great. The only objection is its current price.

This is the third article in a series analyzing whether to invest in Alphabet/Google stock. We are conducting the analysis from a fundamental perspective, using information from Gradement. Here are links to the two previous articles on Alphabet's profitability and static solvency.

In previous posts, we discussed how the economic-financial model analyzes solvency from two different perspectives. We saw that the static part of the model focuses exclusively on the balance sheet, dividing assets and liabilities into categories and analyzing whether each asset category is properly funded. Each category requires a different type of financing. Incorrect financing can indicate that the company may have difficulty repaying its debts in the near future. We concluded that Alphabet fulfills all three conditions to be considered statically solvent.

Now it is time to analyze its dynamic solvency. The term "dynamic" refers to the fact that, unlike the static model which considers a fixed snapshot of the company at a given time (the balance sheet), here we consider the company as a going concern. We analyze whether its daily operations generate sufficient resources to meet all payment commitments as they come due.

Dynamic solvency 101

To analyze a company's solvency from a dynamic point of view, we must check if the company generates sufficient funds from its ordinary activities during an accounting period to meet the payment commitments it has during that same period.

To do so we simply have to check that:

Certain Generated Funds > Certain Payment Commitments

We use the word "certain" because not all generated funds, nor all of the company's payment commitments, affect its dynamic solvency equally. Let's see why.

Certain sources of funds, such as asset sales, capital increases, or new debt, provide funds to the company but not on a regular basis. It is not possible to raise capital, sell assets, or borrow in a recurring or predictable manner. Therefore, the model conservatively does not consider these funds as valid for meeting the company's regular and periodic payment commitments.

The model considers that to meet regular payment commitments, a company must use funds generated on a regular basis from its main activities. These are known as cash flows from operating activities or operating cash flows.

Similarly, not all payment commitments are equal. The model only considers regular payment commitments resulting from the company's ordinary activities. A capital reduction, long-term debt repayment, or the purchase of non-current assets are not regular payments made in the course of ordinary business. The regular payments considered by the model are payments on short-term debt, financing of current assets (mainly inventories), and dividend payments.

All these considerations lead to the following definition of the so-called dynamic solvency ratio:

DS = (Operating Cash Flow - Financing of Current Assets) / (Short-term Debt Repayment + Dividends)

We consider a company to be solvent when its dynamic solvency ratio is greater than 1. This indicates that its operating cash flows, after financing its current assets, are sufficient to cover all short-term debt repayments and any dividend payments.

There is a second definition that excludes dividends, the minimum dynamic solvency ratio:

Minimum DS = (Operating Cash Flow - Financing of Current Assets) / Short-term Debt Repayment

Here, the model does not include dividends as ordinary payment commitments. It assumes that the company, if necessary, can always suspend dividend payments to meet its other obligations. Whether this is a realistic assumption depends on the company. In some cases, suspending a dividend can lead to a significant drop in the company's share price.

Which Model to Use: Static or Dynamic?

Both. A poorly structured balance sheet (i.e., one that does not meet the static solvency conditions) indicates that even if the dynamic solvency condition is currently met, it may not be in the future. Similarly, if a company with a well-structured balance sheet is not generating sufficient funds to cover all its payment commitments, it may become insolvent.

It is always advisable to consider both models in any investment decision. However, since accounting rules allow for more flexibility in valuing balance sheet assets than in calculating cash flows, it is also advisable to give more weight to the dynamic solvency component than to the static one.

The Dynamic Solvency of Alphabet

Now that we understand dynamic solvency, let's calculate it for Alphabet. Since it does not pay dividends, its DS and Minimum DS ratios are identical. The table below lists the values of Alphabet's dynamic solvency ratio for the last ten accounting periods. Remember, a company is considered solvent if the ratio is greater than 1. The higher the value, the more solvent the company.

Dynamic solvency ratio (DS)
2017-12-31 18.65
2016-12-31 5.23
2015-12-31 3.17
2014-12-31 3.09
2013-12-31 2.64
2012-12-31 2.76
2011-12-31 2.34
2010-12-31 2.72
2009-12-31 10.25
2008-12-31 15.49

Alphabet is currently generating 18.65 times more resources than it needs to meet its payment commitments (an average of 6.55 times over the last five accounting periods).

There is no doubt that Alphabet is a solvent company—extremely solvent, both statically and dynamically. It is highly improbable that we will ever see a newspaper headline announcing that Alphabet/Google has filed for Chapter 11.

What's Next

So far, so good. We've seen that Alphabet is extraordinarily profitable and solvent. You might be thinking, "Why should I keep reading? I should run to my computer and place a buy order for a handful of Alphabet shares." Well, you might want to wait for the last post in this series. As is often the case with extremely good companies, the price of their shares also tends to be extremely expensive.

We will analyze Alphabet's share price in the next and final post of this series.