Financial: how to use leverage ratios to detect a company’s financial risk

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Having a large portion of equity indicates that the company is less indebted and therefore less risky.

By Dr Kanika Sachdeva,

One of the essential elements in assessing a company’s financial risk is to assess the relationship between equity and borrowed funds. Leverage ratios such as leverage ratio, leverage ratio, interest coverage ratio, and debt service coverage ratio provide in-depth insight for an investor to assess the company’s potential to pay off long-term obligations. In addition, these ratios highlight the proportion of debt borrowed by the company on its own funds. Having a large portion of equity indicates that the company is less indebted and therefore less risky.

Hypothetical illustration

Assume the following figures for High Earners Ltd. (ET) for the current year: Total liabilities: 50,000; Total equity: 2,000,000; EBITDA (Earning Before Interest, Tax, depreciation and amortization): 7,50,000; Interest charges: 60,000; Net operating income: 2 50,000; Debt service: 35,000; Assets: 1.50,000.

Debt ratio (DER)

It is calculated by dividing the company’s total debt by its equity. For HE, the DER for the current year is 0.25 (total debt of Rs. 50,000 / equity of Rs. 1 50,000). Thus transmitting that against every rupee of equity, HE uses twenty-five paise of debt. If the ratio for the previous period is 0.50, the company has improved its financial stability by meeting its external obligations.

Debt ratio (DAR)

It is calculated by dividing the company’s total debt by its total assets. For HE, the DAR for the current year is 0.33 (total debt of Rs. 50,000 / total assets of Rs. 2,000,000). Therefore, this figure indicates that 33% of HE assets are financed using debt funds. If the ratio for the previous period is 0.25, the company used additional debt funds to meet its asset requirements and therefore indicates a riskier position compared to the prior state.

Interest coverage ratio (ICR)

It is calculated by dividing EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization) by its interest expense. For HE it is 12.5 times (EBITDA of Rs. 7.5,000 / interest expense of Rs. 60,000). This reveals that the ES has the buffer to pay the interest charge approximately 11 times over the actual amount payable. If its interest coverage ratio from the previous period is 10 times, then the company has improved its ability to pay interest expense with current income. The higher the ratio, the better for the business.

Debt Service Coverage Ratio (DSCR)

It is calculated by dividing the NOI (Net Operating Income) by the total service of its debt. The total debt service is calculated by the sum of interest, principal repayments and rent. 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 needed to pay off all of its debt for the current period. If its previous DSCR period is 9 times, then the company has reduced its existing capacity to service all debt obligations.

All of the above ratios can assess the financial capacity of companies to honor their debts. These ratios can be used by the company itself for year-over-year comparison and competitor analysis. With the exception of DER and DAR, for the other two higher ratios, the ratio is better for the company indicating the high stability and less risk of the company. Basically, a business with more debt is considered riskier compared to a business with less debt.

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

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