Your Money: Check solvency position using debt-to-equity ratio

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June 21, 2021 1:45 AM

It is best to consider debt to be the sum of both long-term and short-term lease obligations & borrowings

If its previous year figure was 0.56 times, then the firm has fallen in its solvency position in the current year.If its previous year figure was 0.56 times, then the firm has fallen in its solvency position in the current year.

Investors in general and debt investors in particular have a need to assess the solvency position of their investment candidates. In this context, understanding of debt-to-equity (DE) ratio computation and its inferences helps the investors.

Hypothetical illustration
Let us assume the following figures (in Rs crore) for Hrishikesh Anand Ltd (HA) for its latest financial year: Total of liabilities and shareholders’ funds 30,000; current liabilities 8,000; short-term borrowings 2,000; short-term lease obligations 1,000; long-term borrowings 5,000; long-term lease obligation 2,000; non-current liabilities 10,000; shareholders funds 12,000; cash & cash equivalent 2,000.

Debt-to-equity ratio
It is computed by dividing the debt of a firm by its shareholders’ funds. Lower the DE ratio, better is the solvency position of an entity. One can narrowly define debt by considering only the long-term borrowings. For HA, long-term borrowings to equity is 0.42 times. If its previous year long-term borrowings to equity was 0.54 times, then the firm has improved its solvency position in the current year.

Alternatively, one may consider debt to be the sum of long-term borrowings and long-term lease obligations. For HA, modified debt to equity is 0.58 times (sum of long- term borrowings of Rs 5,000 crore and long term lease obligations of Rs 2,000 crore divided by shareholders’ funds of Rs 12,000 crore). If its previous year figure was 0.56 times, then the firm has fallen in its solvency position in the current year.

Non-current liabilities
We may define debt to be total non-current liabilities. For HA, modified debt to equity is 0.83 times (non-current liabilities of Rs 10,000 crore divided by shareholders’ funds of Rs 12,000 crore). If its previous year figure was 0.96 times, then the firm has improved its solvency position in the current year. The broader definition of debt may include (in addition to the above) either short term borrowings or sum of short-term borrowings and short- term lease obligations or entire current liabilities. Since, the investor is interested in the safety margin irrespective of the time horizon, it is prudent to consider debt to be the sum of long-term borrowings, long-term lease obligations, short-term borrowings and short-term lease obligations. Therefore, the modified DE for HA is 0.83 times (sum of LTB of Rs 5,000 crore, STB of Rs 2,000 crore, LT lease obligations of Rs 2,000 crore and ST lease obligations of Rs 1,000 crore divided by shareholders’ funds of Rs 12,000 crore). If its previous year figure was 0.92, then the firm has improved its solvency positions in the current year.

Some may define debt to be the excess of the sum of LTB, STB, long-term lease obligations and short-term lease obligations over cash and cash equivalent. It is known as net debt. Net DE is computed by dividing net debt by equity. For HA it is 0.67 times. If its previous year figure was 0.71, then the firm has improved in its solvency position in the current year.

We may go by the last two variants as these are broader, conservative, and intuitive in measuring the solvency position. Alternatively, we may consider the market value of equity in the denominator to compute market DE ratio.

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur

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