What Is Ability to Pay? Definition of Ability to Pay, Ability to Pay Meaning and Concept
Definition of ability to pay is an indicator that tries to measure the probability that an individual or an entity has to default on its financial obligations with a creditor.
Ability to pay is the existing probability that a company or an individual may default on the payment of its debts with one or more creditors. This magnitude is used as an indicator that tries to measure the solvency of the company against its debts, enabling it to make decisions in debt relationships with the different creditors.
It is a widely used indicator, usually in the banking sector. The ability of this to measure the credit rating of a person, leads it to be used repeatedly for the evaluation in the approval, or denial, of credits.
Although its use is closely linked to banking, this magnitude can also be used individually. This indicator is also very useful for decision-making in our domestic economy.
What is the ability to pay for?
The ability to pay is a fairly comprehensive indicator. We are talking about an indicator that measures the solvency of a person or a company to face possible debts. When one wants to request a bank loan, as well as a line of credit, this magnitude is one of the many statistics used for decision-making in the approval of said financial products.
Also in personal finances. In the same way, when we apply for a microcredit, a mortgage, as well as a credit card, the ability to pay is also a reliable indicator. The ability to pay has become a very recurring indicator for the control of personal finances. With this indicator, quickly and precisely, we can know the capacity of our finances to support a certain debt.
In the business world, the ability to pay is a widely used indicator. Along with others, the ability to pay is one of the many indicators used in the day-to-day life of a company. This shows us the capacity we have to deal with the payment of creditors, the adoption of investments, as well as the decision making in the financial department. Also the relationship with suppliers, where it is used to make decisions on an ongoing basis.
The ability to pay, in scenarios where what is measured is the ability to pay of a country or a territory, is related to other indicators. To measure the relative solvency of a country before the payment of its obligations, in economics, the payment capacity adopts the name of risk premium. Although it is not the same, the risk premium is a generalized indicator for sovereign debt that measures the existing risk that one country compared to another does not meet its obligations to its creditors. Thus, a country that has a lower risk premium probably has a greater ability to pay.
The greater the ability to pay, the cost of borrowing from creditors tends to be lower. While, the lower the ability to pay, the risk of default increases and the cost of debt, or indebtedness, tends to be higher.
How is the ability to pay calculated?
The analysis of the payment capacity is a necessary analysis, as long as we want to go to a financial institution to request a debt, as well as if we want to control our personal finances. Knowing our payment capacity not only has advantages for decision-making, but it also allows us to know the debt capacity that our finances have in a simple and precise way.
Although there is no generic consensus in the analysis that is carried out to measure the payment capacity of an individual or person, financial institutions do usually take into account a series of common variables. These variables will allow us to know, through a simple formula, the payment capacity of the company or the individual.
If we want to know the payment capacity, for this we will need to know the following information:
- Incidental expenses
- Eventual expenses
(*) Remember that income must be calculated once we have deducted taxes.
First, we make an income relationship, where we include all sources of income. If we have variable income, we must calculate the average of this income, so that we can extract a more constant variable:
- Salary / month: $ 2,000
- Low commercial rent / month: $ 800
- Extra services as a freelancer / month: $ 200
Second, we make, in the same way, a list of all our expenses. Here we enter fixed and variable expenses. If we have an expense that is not given on a monthly basis, we can make a proration, so that we have a monthly fee for the useful comparison of variables:
- Mortgage: $ 250
- Transportation: $ 50
- Leisure: $ 200
- Food: $ 200
- Electricity and water, internet, etc.: 100 $
Third, once we have the total income, as well as the total expenses, we will proceed to calculate the available. The formula to calculate the available is quite easy, since it is enough to subtract income and expenses. The resulting difference is considered the available:
- Total income: $ 3,000
- Total expenses: $ 800
- Available: $ 2,200
Fourth, since we do not usually have such a constant life, in our day to day unforeseen events or expenses may appear that, because they are eventual, we cannot quantify so easily. To do this, we are going to proceed to the method to calculate both eventual and unforeseen expenses. It is enough to add a series of percentages to the available value, resulting from the subtraction between the total income and the total expenses.
For unforeseen expenses, we will apply 20% of the available value. While, for eventual expenses, we will apply a 10% on the available value, but after unforeseen events. Let's see next:
- Unforeseen expenses: Available value * 0.20 = X
- Available after contingencies: Available value - X = Y
Proceeding to the calculation, we obtain the following:
- Unforeseen expenses: $ 2,200 * 0.20 = $ 440
- Available after contingencies: $ 2,200 - $ 440 = $ 1,760
Now we proceed to calculate the amount available after eventual expenses:
- Eventual expenses: Available after contingencies * 0.10 = X
- Available after contingencies: Available after contingencies - X = Y
Now, we proceed to the calculation and obtain the following:
- Eventual expenses: $ 1,760 * 0.10 = $ 176
- Available after eventuals: $ 1,760 - $ 176 = $ 1,584
In this way, everything would already be calculated and we would only have to know our payment capacity. To do this, we are going to calculate it, so that we can place it within a range, in relative terms. In this way, if we want to know the payment capacity, as a percentage, we carry out the following formula:
- Ability to pay: Available after eventuals / Total income = X
If we proceed to the calculation we obtain the following:
- Ability to pay: $ 1,584 / $ 3,000 = 0.528
- Payment capacity (%): 52%
In this way, we have obtained that the payment capacity in the assumption is very high.
The parameters among which the measurement is considered are:
- Below 10%: low capacity.
- Between 10% and 30%: medium capacity.
- Greater than 30%: high capacity.
Given that the capacity in the example is 52%, we find that the payment capacity in this case would be high, so that -in general- you should not have problems when meeting financial obligations.