Deciphering a company’s leverage ratios :: Business Line

Having accumulated a debt of over Rs 9,200 crore as on September 2012, ‘the king of good times’ is now in the midst of bad times.

While raising a certain amount of debt may be a good way of funding new investment, the debt levels must be kept in check lest they lead a company into bankruptcy.

So how do you judge whether debt levels are manageable? Here’s where ratios come in handy.

The debt equity ratio is the ratio of the total liabilities of a company to its shareholder equity. It gives an overall picture of a company’s leverage. Higher the ratio, the more leveraged a company is.

The debt equity ratio for any firm, however, has to be seen in the context of the industry to which it belongs, since some industries inherently involve higher debt levels than others.

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LOADED WITH DEBT

For instance, firms in capital intensive industries such as aviation, iron and steel, construction and so on require heavy investments and higher debt compared to sectors such as software and fast-moving consumer goods which are both cash-rich and require lower debt.

For example, the debt equity ratio for steel major JSW Ispat was as high as 9 (June 2012), and that of infrastructure company IL&FS Transportation Networks was 2.7 (consolidated) in September 2012.

On the other hand, consumer company GSK Consumer Healthcare has no debt, and Godrej Consumer has a low debt-equity ratio of 0.5. Debt is not evil, since equity cannot constantly be raised to meet funding requirements, and will also lead to dilution in earnings.

But with a negative net worth and gigantic debt levels, Kingfisher’s debt-equity is massive by any standard.

SERVICING LOANS

But whether a company is able to service its debt also matters. Thus, even a higher debt-equity ratio may not be a serious concern if the company is in a comfortable position with regard to timely interest payment. Red flags crop up when a company seems unable to meet even interest obligations in a timely manner.

This is where the interest coverage ratio steps in. The interest coverage ratio equals EBIT (earnings before interest and taxes) divided by interest. This ratio reflects a company’s ability to meet its annual interest payment obligations.

Thus Kingfisher, with its losses before interest and taxes, would have found it difficult to service its debt.

But consider the steel sector. Taking the earlier example of JSW Ispat, its high debt is matched by a low interest coverage ratio of 0.53 (June 2012).

On the other hand, SAIL and Tata Steel are better off. These two companies had debt-equity ratios of 0.46 and 0.55, respectively, and coverage ratios of 6.23 and 6.12 (as on March, 2012).

MEETING OBLIGATIONS

So not only do these two companies have a smaller debt relative to their equity but they are also strongly placed when it comes to meeting their interest obligations. This makes it easy for them to secure debt funds for future needs. JSW Ispat, though, is likely to find it tough to get more debt to meet requirements given its high debt and low coverage.

Another leverage ratio, but slightly harder to calculate, is the debt service coverage ratio, which is used to check if a company can meet both interest and principal payments.

The ratio is calculated thus: (net profit + non cash operating expenses such as depreciation+ Non operating adjustments like loss on sale of fixed assets) / (interest + instalments).

A value below 1 indicates that a company does not have sufficient funds to meet its debt obligations. For example, a debt service coverage ratio of 0.80 would mean a company is capable of meeting only 80 per cent of its annual debt payments.