By Dr. Kanika Sachdeva,
One of the pivotal components to evaluate the monetary riskiness of the firm is to assess the relation among personal funds and borrowed funds. Leverage ratios such as debt to equity ratio, debt to asset ratio, interest coverage ratio, and debt service coverage ratio provides a deep insight to an investor to gauge upon the firm’s prospective to spend its extended-term obligations. Moreover, these ratios highlight the proportion of debt borrowed by the business against its personal funds. Having a significant chunk of personal funds indicates that the business is significantly less leveraged therefore significantly less risky.
Hypothetical Illustration
Let us assume the following figures for High Earners Ltd. (HE) for the existing monetary 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 existing year is .25 (Total debt of Rs. 50,000 / shareholder’s equity of Rs. 1,50,000). Thereby conveying that against just about every single rupee of shareholder’s equity HE is utilizing twenty-5 paise of debt. If the prior period ratio is .50 then the business has enhanced its monetary 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 existing year is .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 utilizing the debt funds. If the prior period ratio is .25 then the business has applied further debt funds to meet its requirement of assets and therefore 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 instances (EBITDA of Rs. 7,50,000 / interest expense of Rs. 60,000). This reveals that HE has the buffer to spend the interest expense of about 11 instances more than and above the actual quantity payable. If its prior period interest coverage ratio is 10 instances, then the firm has enhanced its capacity to spend its interest expense with its existing earnings. Higher the ratio is superior 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 instances (NOI of Rs. 2,50,000 / debt service of Rs. 35,000), reflecting that HE has the money in multiples of 7.14 instances expected to spend all its debt for the existing period. If its prior period DSCR is 9 instances, then the firm has lowered its current capacity of serving all debt obligations.
All above ratios can assess companies’ monetary capacity to meet their debt obligations. These ratios can be applied by the firm itself for YoY comparison and competitor evaluation. Except for DER and DAR, for other two ratios greater the ratio is superior for the firm indicating the sturdy stability and significantly less riskiness of the firm. Fundamentally, a more leverage business is thought of to be riskier in contrast to a significantly less leveraged business.
(The author is Associate Professor, Sushant University, Gurugram, Haryana. Views expressed are private and do not reflect the official position or policy of the The Spuzz Online.)