In our first topic on Fundamental Analysis; we covered “Liquidity Ratios”. This topic is a step further on the understanding of fundamental analysis, where we would cover another very important group of financial ratios i.e. Leverage Ratios.
What is Leverage? Leverage or Financial Leverage is the amount of debt a company borrows to expand the business or to buy more assets; this gives a firm the opportunity to grow faster and tap into business opportunity which otherwise without borrowed money is not possible.
Pros and Cons of Leverage: While most of the businesses try to be debt free; but in real world every business house have had to borrow money at some point in time to grow. Consider a company with an outlook of growth in demands, wants to invest in plant and machinery; lack of funds could take away that opportunity. In this case if firm expects the return from the expansion of business will be able to cover interest charges then company should certainly avail the debt otherwise firm should avoid leverage.
Till now we understood; Financial Leveraging can be used as tool to expand and grow faster but too much of leveraging can be very detrimental for any firm especially under economic downturn scenario. With regular due payments of interest and principal; debt takes away a large chunk of the profit earned by the business or in an extreme case a firm might have to avail more loans or might have to apply for restructuring of interest and principal payments. With interest payments taking a large chunk out of top-line sales, a company will have less cash to fund marketing, research and development and other important investments.
Zero Leverage (Debt) good or bad: Low or zero leverage might also indicate company is too cautious and let go opportunity to grow; reason might be company does not have confidence in the business or the product.
Zero or low leverage might also indicate; low operating margins and company might not be able to cover interest payments from the expansion.
Leverage Summary: If a company will be able to cover the interest and principal payments from the expansion of business then certainly company should avail the leverage otherwise firm might struggle to make regular interest payments, investors are likely to lose confidence and bid down the share price. In more extreme cases, bankruptcy becomes a very real possibility.
Leverage Ratios: Leverage ratios mainly deal with the overall extent of the company’s debt, and help us understand the company’s financial leverage better.
We will cover three leverage ratios;
- Debt to Equity Ratio
- Debt to Asset Ratio
- Interest Coverage Ratio
Debt to Asset Ratio: Debt to Asset ratio can be used to determine if the business will be able to pay all of its debts if the business is closed immediately. Debt to Asset ratio is calculated by dividing total debt with total assets of the firm.
Debt to Asset Ratio = Total Debt / Total Assets
A company having a debt to asset ratio of less than 1 is considered to be good for investment. If the ratio is greater than 1, the company is considered as highly leveraged.
Debt to Equity Ratio:
The Debt/Equity Ratio is calculated by dividing company’s total liabilities by its shareholder’s equity. The ratio is used to calculate a company’s financial leverage. The debt/equity ratio is also known as Risk Ratio or Gearing Ratio.
Debt/ Equity Ratio = Total Liabilities/Total Shareholder Equity
NOTE: Assets = Liabilities + Shareholder Equity
It is most often used to gauge the extent to which a company is taking on debt as a means of leveraging its assets. A high debt/equity ratio is often associated with high risk; it means that a company has been aggressive in financing its growth with debt.
If a lot of debt is used to finance growth, a company could potentially generate more earnings than it would have without that financing. If leverage increases earnings by a greater amount than the debt’s cost (interest), then shareholders should expect to benefit. However, if the cost of debt financing outweighs the increased income generated, share values may decline. The cost of debt can vary with market conditions, thus unprofitable borrowing may not be apparent at first.
Issues with Debt/Equity Ratio
- Optimal Debt/ Equity Ratio: Optimal Debt/ Equity Ratio factor considered for the fundamental analysis of a company may differ from industry to industry. Example- Auto Industry may have a high debt/equity ratio (above 2), because it’s a capital intensive sector (High leverage ratios in slow growth industries with stable income represent an efficient use of capital), while an IT firm may have low debt/equity ratio (below 0.5) because it’s a service industry (low leverage ratios in fast growth industries with quick income represent an efficient use of capital).
- Treatment of preferred stock: Preferred stock is sometimes considered equity, but the preferred dividend, par value, and liquidation rights makes this kind of equity look like debt. Including preferred stock in total debt will increase the D/E ratio and make a company look more risky. Including preferred stock in the equity portion of the D/E ratio will increase the denominator and lower the ratio.
- Treatment of Unearned Income: Example- A firm ‘X’ has to supply goods worth Rs.20,00,000, the payment of which will be made after full order is complete. Firm ‘X’ also purchases inventory worth Rs.5,00,000. Now, if the work is still in progress these amounts will increase the numerator by Rs.20,00,000 and denominator by Rs.5,00,000 which will increase the ratio, but would be a devious indication.
Below are the numbers for HDFC Bank for Mar 2018/2017.
Interest Coverage Ratio: One of the biggest shortcomings of debt to asset or debt to equity ratios is that they look at the total amount of borrowing, not the company’s ability to actually service its debt.
The interest coverage ratio also referred to as debt service ratio or the debt service coverage ratio. This ratio is used to measure the company’s ability to meet its interest –payment obligation. This ratio helps us interpret how easily a company can pay its interest payments.
A higher Interest coverage ratio indicates that the firm is financially well placed to make the interest payments. Few firms might look highly leveraged but those firms might have high interest coverage ratio that means firms generate enough cash to make interest payments which gives positive outlook of the business growth and also indicate that leveraged funds have been managed efficiently.
Interest Coverage Ratio = Operating Income / Interest Expense
Or can be mentioned as
Earnings before Interest and Tax / Interest Payment
Below table gives Interest coverage ratio for HDFC Bank:
We could easily conclude that HDFC Bank is well placed to cover interest payments and long term debt.
Important Note: Though ratios greatly helps in analyzing the financial health of a firm but standalone ratio could give wrong interpretation of financial activities. Before coming to any conclusion we need study a set of ratios along with balance sheet before making any investment decision.