NSE IFSC – Debt to equity ratio

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NSE IFSC Debt to equity ratio
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As an investor, you must evaluate the company
before making a decision on whether to invest in
it or not. This evaluation would help you take
trades with most potential for profit and least
probability of risk. Such evaluation is carried
out through Fundamental Analysis. Fundamental
Analysis involves evaluating the companys
financial status by studying its Balance Sheet,
Income Statement (also called Profit and Loss
Statement), Cash Flow Statement, and its
Financial Ratios. Out of these, Financial Ratios
help us compare two or more financial parameters
of the company to understand its financial
status better. Using these ratios, you can
understand the companys financial health and
also compare the company to its peers that
operate in the same industry or sector. One such
parameter is Debt to Equity Ratio. In this blog,
we will find out more about Debt to Equity Ratio
and the debt to equity ratio formula.
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Debt and Equity
In order to understand this ratio, we first need
to understand the definition of each term. Every
company raises capital in two ways, namely, Debt
financing and Equity Financing. Debt Financing
is essentially borrowing money from a creditor by
taking a loan at a fixed interest rate. Equity
financing refers to issuing of equity shares of
the company to the general public (through IPOs
and FPOs). Equity financing is more expensive,
dilutes earnings per share of existing
shareholders, and is a time consuming
process. Debt financing involves only interest
payments as the primary cost. This can be
deducted from their overall tax liability and
thus makes it the preferred form of financing.
However, Debt financing comes with Credit Risk.
In the scenario where the borrower fails to
repay the principal or interest amount, investors
(creditors) are left with no choice but to
declare it as a non-performing asset.
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Debt to Equity Ratio Formula and How to Interpret
It
Now, let us understand what is Debt to Equity
Ratio and how it is calculated. As the name
suggests, this financial ratio calculates the
companys total debt versus the equity.
Calculating and evaluating the Debt to Equity
Ratio tells investors how much of the companys
assets are debt financed. This would aid them in
measuring credit risk in case the company is
liquidated. Debt to Equity Ratio is also known
as Gearing Ratio or Risk Ratio. It comes under
Leverage Ratios or Solvency Ratios. These ratios
help analysts compare the debt level of a
company to its equity and assets. This allows
them to understand the companys ability to meet
its long term debt obligations.
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Debt to Equity ratio is calculated by dividing tot
al liabilities of the company by its
shareholders equity.
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Where, Total Liabilities refers to long-term debt
with a minimum maturity period of more than five
years. It is a non-current liability and is not
the same as short-term debt which must be repaid
within five years. Quick Ratio or Current Ratio
would be better suited to understand the
companys ability to repay its short-term debts
or liabilities. As Debt to Equity Ratio
calculates whether the company can repay its
long-term debt, we can deduce that a high value
for this ratio would not be a favourable sign. A
high debt to equity ratio would signify that the
company does not have enough equity to repay its
debts and thus makes it a high-risk investment.
This is because if a company goes bankrupt, on
liquidation, it is first obligated to pay off
its debt liabilities before it can pay back any
investments made by equity shareholders. A
company with a Debt to Equity Ratio of 11 is
considered to be safer as the company has equal
amount of debt and equity. Whereas, a company
with a debt to equity ratio of 2 or more is
considered to be a risky investment since the
company owes twice the amount of debt as
compared to its equity.
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Ideal Debt to Equity Ratio
When evaluating a company, we must consider its
financial ratios and also compare them to the
other companies operating in the same sector or
industry. Knowing the ideal debt to equity ratio
for a company aids us in assessing the company
correctly. Some companies may have negative debt
to equity ratios. It signifies that the company
pays high interest on its debt obligations and
earns low return on equity. Or it may indicate
that the company has negative networth. For
example, SpiceJet has a debt to equity ratio of
-0.25. Some companies have a low or zero debt to
equity ratio. Generally, these are considered
safer investments but it may also indicate that
the company is not taking advantage of financial
leverage for increasing its profits. It may not
be utilizing the opportunity to expand its
business and increase its profits by taking debt.
At times, the company could have low debt to
equity ratio but not perform well in other
aspects, making it a bad investment.
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However, assuming that a company is a bad
investment based only on its high debt to equity
ratio is also incorrect. Some industries are
capital intensive and thus have high Debt to
Equity Ratios. Companies operating in the
automobile, power, utilities, and financial
sector typically have high debt to equity ratio
while also being good avenues for investment.
This makes it necessary to consider the average
debt to equity ratio of the industry before
making a decision. The interest Coverage Ratio
is an important financial parameter that can help
us make the final decision in case of companies
having a high debt to equity ratio. This ratio
tells us about the companys ability to pay the
interest due on their liabilities. High Interest
Coverage Ratio, above 1.5 is considered to be a
good sign for creditors. An interest coverage
ratio of less than 1.5 indicates that the company
may default on its interest payments and are not
good investments.
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Implications of High Debt to Equity Ratio
A high debt to equity ratio indicates several
factors about the company. We shall discuss them
in this segment. Reduction in Equity Ownership
A high debt to equity ratio signifies that
shareholders equity is less and thus they have
lower claim on the companys earnings and assets
as compared to the lenders and creditors. This
also means that a large portion of the earnings
is used for debt servicing, reducing the
earnings per share for the shareholders.
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Limitations of Debt to Equity Ratio
The most common mistake made by investors when
considering the debt to equity ratio of the
company is not checking the industry standard. As
different industries have different capital
requirements and different time frames for
growth, a debt to equity ratio levels for each
industry are different. To rectify this error, we
must compare the ratio with the level for the
rest of the companies operating in the same
industry. Furthermore, while Debt to Equity
Ratio is a good parameter to assess the financial
health of the company, we must also remember to
check other financial ratios of the company
before making our investment decisions. At the
very least, an investor must check whether the
company has a good return on equity before
investing.
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