Understand what these ratios signify and how to analyse companies using them.
When evaluating a company’s financial health, numerous metrics and ratios exist. But everyone would admit that understanding these ratios and numbers is sometimes confusing. Moreover, you would often notice that ratios are interrelated and tell you a lot about the company’s financial health.
Today, we will discuss two ratios that complement each other and are very important to analyse – Debt to Equity Ratio and Interest Coverage Ratio. These ratios offer valuable insights into how a company manages its debt and whether it can meet its interest obligations.
This article will delve into these ratios, their roles in financial analysis, and when to prioritise one over the other.
What is the Debt-to-Equity Ratio?
The Debt-to-Equity (DE ratio) is a metric that provides insight into a company’s capital structure. It measures the proportion of a company’s debt relative to its equity. In simpler terms, it indicates how much of a company’s funding comes from debt compared to shareholders’ equity.
To understand the concept better, let’s break down the formula of the DE ratio.
Debt to Equity Ratio = Company’s Total Liabilities / Shareholder Equity
If we take a simple example, let’s say you wish to open a new gift shop and would need Rs 5 lakh to set it up. But, currently, you have Rs 2.5 lakh, and you are borrowing the remaining 2.5 lakh from a bank. So, here, the DE ratio of your company is 1:1. This means 50% of your capital is financed by your own money and 50% by debt. Hence, for every rupee of equity, you have one rupee of debt.
A higher DE ratio indicates that the company’s assets are financed by debt more than its own capital. In contrast, a lower ratio suggests a more conservative approach with a higher reliance on equity financing.
What is the Interest Coverage Ratio?
The Interest Coverage Ratio (ICR) is another financial metric that assesses a company’s ability to meet its interest obligations. In simple words, it tells us if a company can pay interest on its borrowed capital by generating enough operating income to cover its interest expenses comfortably.
The formula to calculate the interest coverage ratio is:
Interest Coverage Ratio (ICR) = Operating Income (EBIT)/ Interest Expenses
Here, operating income (EBIT) represents a company’s earnings before interest and taxes. It reflects the profitability of a company’s core operations. And interest expenses include all the interest payments a company is obligated to make on its outstanding debt.
A higher interest coverage ratio indicates that a company has a more substantial cushion to meet its interest obligations, indicating a lower financial risk. On the other hand, a lower interest coverage ratio suggests that the company may struggle to cover its interest expenses, potentially raising concerns about solvency.
Difference Between Debt-to-Equity Ratio and Interest Coverage Ratio
While both DE and ICR are essential financial ratios, they serve distinct purposes in assessing a company’s financial health.
1. Focus on Capital Structure
DE Ratio primarily assesses how a company funds its operations and expansion plans. A high DE ratio may indicate higher financial risk due to excessive reliance on debt. For example, consider the case of Suzlon Energy, where the company was from a growing sector. But, taking on a high debt burden ultimately led to a deterioration in its financial health. Hence, its share price fell from a position of prosperity to one of financial distress.
Whereas ICR concentrates on the company’s ability to pay interest on the company’s existing debt. A low ICR may signal potential issues with debt repayment.
2. Time Horizon
DE Ratio provides a snapshot of the company’s capital structure at a specific point in time.
The interest coverage ratio evaluates the company’s ability to meet interest payments in the short term.
3. Use in Different Scenarios
DE Ratio is valuable for long-term financial planning and assessing the company’s overall financial risk. The interest coverage ratio is crucial when evaluating a company’s short-term financial stability and ability to cover interest expenses.
How to Use Debt-to-Equity and Interest Coverage Ratios in Company Analysis?
1. Assessing Risk Tolerance
A higher DE ratio might be acceptable for established companies with stable cash flows but could be risky for startups or those in volatile industries.
A lower ICR may indicate that the company is at risk of defaulting on its interest payments. Hence, you must have a closer look at its operations and financial stability.
2. Comparative Analysis
Compare the DE ratio of a company with industry peers to understand where it stands in terms of borrowing. Like the DE ratio, compare the ICR with industry benchmarks to gauge a company’s ability to handle its interest obligations.
3. Monitoring Changes Over Time
Track changes in the DE ratio over multiple periods. A consistent increase might suggest a shift toward a riskier capital structure.
Similarly, observe trends in the ICR to identify potential issues, especially if they decrease over time.
To conclude, the debt-to-equity and interest coverage ratios are crucial for evaluating a company’s financial health and risk profile. Both ratios play complementary roles in offering comprehensive financial analysis, and the choice of which to prioritise depends on the specific context and goals of the analysis.
By understanding these ratios and their significance, investors can make more informed decisions about a company’s financial well-being.
*The companies mentioned are for information purposes only. This is not an investment advice.