Organisations which are proficiently controlled recognise that debt can be beneficial in situations where the funds are being invested into a venture that will yield rewards higher than the amount paid for interest. Financial advisors would advise using debt sensibly in order to maximise returns on equity.
If a company accumulates too much debt, the interest charges can reduce its shareholders’ profits. It is essential to be aware of the difference between good and bad debt, and leverage ratios are an effective method of assessing a company’s financial reliance on borrowing.
We will analyse these leverage ratios: quick ratio, current ratio, debt-to-equity, and interest coverage.
We have been looking at Amara Raja Batteries Limited (ARBL) to get a grasp of leverage ratios. However, let’s take a closer look at a company with substantial debt on its balance sheet. Jain Irrigation Systems Limited (JISL) is an excellent example of this. You can have your practice, too, by calculating the ratios for a company of your choice.
Interest Coverage Ratio:
The interest coverage ratio, sometimes called the debt service ratio or debt service coverage ratio, is an indicator of a company’s financial health. It allows us to assess how much money the company is making against its interest payments. For instance, if its liabilities stand at Rs.100 whilst income is Rs.400, there is enough capital to cover financing obligations. However, if this relation is reversed and the ratio is too low, then it could indicate a high risk of bankruptcy or default on payments.
Here’s how you can calculate the interest coverage ratio:
Earnings before Interest and Tax are divided by Interest Payment
The ‘Earnings before Interest and Tax’ (EBIT) can be calculated as follows:
EBITDA – Depreciation & Amortisation
We can use this ratio to analyse Jain Irrigation Limited. Here is their Profit and Loss statement for FY 14, with Finance costs highlighted in red:
We know that revenue – expense = EBITDA
To calculate expenses, we deduct Finance costs (Rs.467.64Crs) and Depreciation & Amortisation expenses (Rs.204.54) from Rs.5730.34 Crs, the total expenses.
Therefore EBITDA = Rs.5828.13 – 5058.15 Crs
EBITDA = Rs. 769.98 Crs
As we already know, EBIT is equal to EBITDA – [Depreciation & Amortisation]
= Rs.769.98 – 204.54
= Rs. 565.44
We know Finance Cost = Rs.467.64,
Hence Interest coverage is:
= 565.44/ 467.64
The ‘x’ in the preceding figure signifies a multiple; therefore, 1.209x should be read as 1.209 ‘multiplied by’.
The interest coverage ratio of 1.209x implies that Jain Irrigation Limited is generating an EBIT of 1.209 times for each Rupee of the interest payment obligation.
Debt to Equity Ratio:
This ratio is straightforward to calculate; both variables needed can be found in the Balance Sheet. It’s a measure of the total debt capital in relation to the total equity capital. A value of 1 signals an equal amount of debt and equity capital, whilst higher debt to equity (greater than 1) shows increased leverage, so one should tread cautiously.
Results below 1 indicate a higher proportion of equity capital in comparison to debt.
Here’s how we can calculate Debt to Equity ratio:
[Total Debt/Total Equity]
Please remember that this total debt encompasses both short- and long-term liabilities.
This Balance Sheet for JSIL features total equity, long and short-term debt, with the relevant information being highlighted.
Total debt = Long term borrowings + Short term borrowings
= 1497.663 + 2188.915
Total Equity is Rs.2175.549 Crs
Thus, here’s how Debt to Equity ratio will be calculated:
= 3686.578 / 2175.549
Debt to Asset Ratio:
This ratio offers insight into the way a company has chosen to finance its assets. It shows the fraction of assets that are financed by debt.
The equation to calculate it is:
Total Debt / Total Assets
Based on the Balance Sheet, we have the information that JSIL’s total debt amounts to Rs.3686.578 Crs, while the total assets are recorded as Rs.8204.447 Crs.
Debt to Asset ratio is:
=3686.578 / 8204.44
= 0.449 or ~45%.
Roughly 45% of JSIL’s assets are financed by debt capital and creditors, meaning the owners only have to account for the remaining 55%. This higher number of debt-funded assets may cause an investor concern as it suggests a larger level of leverage and risk.
Financial Leverage Ratio
In the preceding chapter, we examined the financial leverage ratio in connection with the return on equity. This provides valuable insights into the extent to which equity is employed to finance assets.
The formula for computing the financial leverage ratio is:
The leverage ratio, also known as the financial leverage ratio, is calculated by dividing the average total assets by the average total equity.
Upon examining JSIL’s balance sheet for FY14, it is evident that the average total assets amount to Rs.8012.615, while the average total equity is Rs.2171.755. This ratio provides insight into the company’s financial leverage.
8012.615 / 2171.755
JSIL holds Rs.3.68 worth of assets for each unit of equity, so its leverage is high.