Debt Ratios
These ratios give users a general idea of the company’s overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy. The ratios covered in this section include the debt ratio, which is gives a general idea of a company’s financial leverage as does the debt-to-equity ratio. The capitalization ratio details the mix of debt and equity while the interest coverage ratio and the cash flow to debt ratio show how well a company can meet its obligations.
Overview Of Debt
Before discussing the various financial debt ratios, we need to clear up the terminology used with “debt” as this concept relates to financial statement presentations. In addition, the debt- related topics of “funded debt” and credit ratings are discussed below.
There are two types of liabilities - operational and debt. The former includes balance sheet accounts, such as accounts payable, accrued expenses, taxes payable, pension obligations, etc. The latter includes notes payable and other short-term borrowings, the current portion of long-term borrowings, and long-term borrowings. Often times, in investment literature, “debt” is used synonymously with total liabilities. In other instances, it only refers to a company’s indebtedness.
The debt ratios that are explained herein are those that are most commonly used. However, what companies, financial analysts and investment research services use as components to calculate these ratios is far from standardized.
In general, debt analysis can be broken down into three categories, or interpretations: liberal, moderate and conservative.
Liberal - This approach tends to minimize the amount of debt. It includes only long-term debt as it is recorded in the balance sheet under non current liabilities.
Moderate - This approach includes current borrowings (notes payable) and the current portion of long-term debt, which appear in the balance sheet’s current liabilities; and of course, the long-term debt. In addition, redeemable preferred stock, because of its debt-like quality is considered to be debt. Lastly, as a general rule, two-thirds (roughly one-third goes to interest expense) of the outstanding balance of operating leases, which do not appear in the balance sheet, are considered debt principal. The relevant figure will be found in the notes to financial statements and identified as “future minimum lease payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year.”
Conservative - This approach includes all the items used in the moderate interpretation of debt, as well as such non-current operational liabilities such as deferred taxes, pension liabilities and other post-retirement employee benefits.
Investors may want to look to the middle ground when deciding what to include in a company’s debt position. With the exception of unfunded pension liabilities, a company’s non-current operational liabilities represent obligations that will be around, at one level or another, forever - at least until the company ceases to be a going concern and is liquidated. Also, unlike debt, there are no fixed payments or interest expenses associated with non-current operational liabilities. In other words, it is more meaningful for investors to view a company’s indebtedness and obligations through the company as a going concern, and therefore, to use the moderate approach to defining debt in their leverage calculations.
Funded debt is a term that is seldom used in financial reporting. Technically, funded debt refers to that portion of a company’s debt comprised, generally, of long-term, fixed maturity, contractual borrowings. No matter how problematic a company’s financial condition, holders of these obligations, typically bonds, cannot demand payment as long as the company pays the interest on its funded debt. In contrast, long-term bank debt is usually subject to acceleration clauses and/or restrictive covenants that allow a lender to call its loan, i.e., demand its immediate payment. From an investor’s perspective, the greater the percentage of funded debt in the company’s total debt, the better.
Lastly, credit ratings are formal risk evaluations by credit agencies such as CRISIL, ICRA, CARE, and Fitch - of a company’s ability to repay principal and interest on its debt obligations, principally bonds and commercial paper. Obviously, investors in both bonds and stocks follow these ratings rather closely as indicators of a company’s investment quality. If the company’s credit ratings are not mentioned in their financial reporting, it’s easy to obtain them from the company’s investor relations department.
The Debt Ratio
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995 (balance sheet) and total assets of 22,036 (balance sheet). By dividing, the equation provides
the company with a low leverage as measured by the debt ratio of 9%. The easy-to-calculate debt ratio is helpful to investors looking for a quick take on a company’s leverage. The debt ratio gives users a quick measure of the amount of debt that the company has on its balance sheets compared to its assets.
The more debt compared to assets a company has, which is signalled by a high debt ratio, the more leveraged it is and the riskier it is considered to be. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble. However, one thing to note with this ratio: it isn’t a pure measure of a company’s debt (or indebtedness), as it also includes operational liabilities, such as accounts payable and taxes payable.
Companies use these operational liabilities as going concerns to fund the day-to-day operations of the business and aren’t really “debts” in the leverage sense of this ratio. Basically, even if you took the same company and had one version with zero financial debt and another version with substantial financial debt, these operational liabilities would still be there, which in some sense can muddle this ratio.
The use of leverage, as displayed by the debt ratio, can be a double-edged sword for companies. If the company manages to generate returns above their cost of capital, investors will benefit. However, with the added risk of the debt on its books, a company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company’s capital structure.
Debt-Equity Ratio
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total liabilities of 1,995 (balance sheet) and total shareholders’ equity of 22,306 (balance sheet). By dividing, the equation provides the company with a relatively low percentage of leverage as measured by the debt-equity ratio at 9%. A conservative variation of this ratio, which is seldom seen, involves reducing a company’s equity position by its intangible assets to arrive at a tangible equity, or tangible net worth, figure. Companies with a large amount of purchased goodwill form heavy acquisition activity can end up with a negative equity position.
The debt-equity ratio appears frequently in investment literature. However, like the debt ratio, this ratio is not a pure measurement of a company’s debt because it includes operational liabilities in total liabilities. Nevertheless, this easy-to-calculate ratio provides a general indication of a company’s equity-liability relationship and is helpful to investors looking for a quick take on a company’s leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.
Capitalization Ratio
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had total long-term debt of 0 (balance sheet), and total long-term debt and shareholders’ equity (i.e., its capitalization) of 22,036 (balance sheet). By dividing, the equation provides the company with a zero leverage as measured by the capitalization ratio. A company’s capitalization (not to be confused with its market capitalization) is the term used to describe the makeup of a company’s permanent or long-term capital, which consists of both long-term debt and shareholders’ equity. A low level of debt and a healthy proportion of equity in a company’s capital structure is an indication of financial fitness.
Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, successful this formula may seem, it does require a company to maintain a solid record of complying with its various borrowing commitments.
A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab more market share. As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company’s total capital base, which is the capital mobilized by shareholders and lenders.
Interest Coverage Ratio
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had earnings before interest and taxes (operating income) of 7,520 (income statement), and total interest expense of 0 (income statement). This equation provides the company with an Infinite margin of safety due to lack of leverage. The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. While the non-payment of debt principal is a seriously negative condition, a company finding itself in financial/operational difficulties can stay alive for quite some time as long as it is able to service its interest expenses.
In a more positive sense, prudent borrowing makes sense for most companies, but the operative word here is “prudent.” Interest expenses affect a company’s profitability, so the cost-benefit analysis dictates that borrowing money to fund a company’s assets has to have a positive effect. An ample interest coverage ratio would be an indicator of this circumstance, as well as indicating substantial additional debt capacity. Obviously, in this category of investment quality, XYZ would go to the head of the class.
Cash Flow To Debt Ratio
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net cash provided by operating activities (operating cash flow as recorded in the statement of cash flows) of 5,876 (cash flow statement), and total debt of 0 (balance sheet). By dividing, the equation provides the company with infinite margin of debt coverage. A more conservative cash flow figure calculation in the numerator would use a company’s free cash flow (operating cash flow minus the amount of cash used for capital expenditures).
A more conservative total debt figure would include, in addition to short-term borrowings, current portion of long-term debt, long-term debt, redeemable preferred stock and two-thirds of the principal of non-cancel-able operating leases. In the case of XYZ, their debt load is nil so the resulting cash flow to debt ratio percentage is off the chart. In this instance, this circumstance would indicate that the company has ample capacity to borrow a significant amount of money, if it chose to do so, as opposed to indicating its debt coverage capacity.
Under more typical circumstances, a high double-digit percentage ratio would be a sign of financial strength, while a low percentage ratio could be a negative sign that indicates too much debt or weak cash flow generation. It is important to investigate the larger factor behind a low ratio. To do this, compare the company’s current cash flow to debt ratio to its historic level in order to parse out trends or warning signs.
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