Financial Bites: How to use leverage ratios to sniff out company’s financial riskiness

July 03, 2021 2:52 PM

Leverage ratios such as debt to equity ratio, debt to asset ratio, interest coverage ratio, and debt service coverage ratio offers a deep insight to an investor to gauge upon the firm’s potential to pay its long-term obligations.

Having a major chunk of own funds indicates that the company is less leveraged hence less risky.

By Dr. Kanika Sachdeva,

One of the pivotal elements to evaluate the financial riskiness of the firm is to assess the relation between own funds and borrowed funds. Leverage ratios such as debt to equity ratio, debt to asset ratio, interest coverage ratio, and debt service coverage ratio offers a deep insight to an investor to gauge upon the firm’s potential to pay its long-term obligations. Moreover, these ratios highlight the proportion of debt borrowed by the company against its own funds. Having a major chunk of own funds indicates that the company is less leveraged hence less risky.

Hypothetical Illustration

Let us assume the following figures for High Earners Ltd. (HE) for the current financial year: Total liabilities: 50,000; Total Equity: 2,00,000; EBITDA (Earning Before Interest, Tax, depreciation & Amortization): 7,50,000; Interest Expense: 60,000; Net Operating Income: 2,50,000; Debt Service: 35000; Assets:1,50,000.

Debt-to-Equity Ratio (DER)

It is computed by dividing the firm’s total debt to its shareholders equity. For HE, the DER for the current year is 0.25 (Total debt of Rs. 50,000 / shareholder’s equity of Rs. 1,50,000). Thereby conveying that against every single rupee of shareholder’s equity HE is using twenty-five paise of debt. If the previous period ratio is 0.50 then the company has improved its financial stability by paying off its external obligations.

Debt-to-Asset Ratio (DAR)

It is computed by dividing the firm’s total debt to its total assets. For HE, the DAR for the current year is 0.33 (Total debt of Rs. 50,000 / total assets of Rs. 2,00,000). Therefore, this figure indicates that 33% of HE’s assets are financed by using the debt funds. If the previous period ratio is 0.25 then the company has used additional debt funds to meet its requirement of assets and hence indicates a riskier position in comparison to earlier state.

Interest Coverage Ratio (ICR)

It is calculated by dividing EBITDA (Earnings Before Interest, Tax, depreciation & Amortization) by its interest expense. For HE, it is 12.5 times (EBITDA of Rs. 7,50,000 / interest expense of Rs. 60,000). This reveals that HE has the buffer to pay the interest expense of around 11 times over and above the actual amount payable. If its previous period interest coverage ratio is 10 times, then the firm has enhanced its capacity to pay its interest expense with its current earnings. Higher the ratio is better for the firm.

Debt Service Coverage Ratio (DSCR)

It is calculated by dividing NOI (Net Operating Income) by its total debt service. Total debt service is calculated by the summation of interest, principle repayments and lease payments. For HE, it is 7.14 times (NOI of Rs. 2,50,000 / debt service of Rs. 35,000), reflecting that HE has the cash in multiples of 7.14 times required to pay all its debt for the current period. If its previous period DSCR is 9 times, then the firm has lowered its existing capacity of serving all debt obligations.

All above ratios can assess companies’ financial capacity to meet their debt obligations. These ratios can be used by the firm itself for YoY comparison and competitor analysis. Except for DER and DAR, for other two ratios higher the ratio is better for the firm indicating the strong stability and less riskiness of the firm. Fundamentally, a more leverage company is considered to be riskier in contrast to a less leveraged company.

(The author is Associate Professor, Sushant University, Gurugram, Haryana. Views expressed are personal and do not reflect the official position or policy of the Financial Express Online.)

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