Debt is an important source of funds for a company especially when it operates in a capital intensive sector such as construction, metals, and power.
However, it becomes a major concern when the business is no more profitable enough to pay for the interest or principal or both.
This is evident from the recent bankruptcy filings of several companies with the National Company Law Tribunal.
For investors, it therefore becomes necessary to find out a companys ability to service debt by using various leverage ratios.1.
What is a financial leverageIt is the extent of a firms funding through fixed income securities such as bank loans, commercial papers and external commercial borrowings.
Since the debt component in a firms capital structure tends to improve the return on equity, it is also referred to as leverage or gearing.2.
Does that mean higher the debt, better it would be for profitabilityNot really.
The ability of debt to gear up profitability ratios depends upon the efficiency of operations.
If operating profit is not enough to pay for interest, debt becomes a drag on the companys financial performance.3.
What are the tools to find out the extent of indebtednessThere are several financial tools called as leverage ratios that investors can use.
The debt-equity (D/E) ratio is among the most popular leverage ratio.
It shows the proportion of borrowings relative to shareholders equity.
A ratio above one indicates that the company is using more debt to finance growth.4.
What is the degree of financial leverage (DFL)DFL is calculated as the ratio of earnings before interest and tax (EBIT) in the numerator and EBIT less interest in the denominator.
A higher DFL means earnings will be more volatile and the companys performance will be impacted severely in times of low profits.5.
What are interest coverage and debt/EBITDA ratiosInterest coverage is obtained by dividing EBIT by interest outgo.
It depicts a companys ability to service debt.
A ratio below or close to one reflects that the company may struggle to pay interest in the near term.
Debt/EBITDA reflects the number of years it would take the company to repay principal through operating profit before depreciation (EBITDA).
A higher ratio reflects longer period of repayment, which may discourage lenders from issuing fresh loan.