Investors in general and bond investors in particular need to assess the creditworthiness of their investment candidates. In this context, understanding the calculation of the debt-to-equity (DE) ratio and its inferences helps investors.
Assume the following figures (in Rs crore) for Hrishikesh Anand Ltd (HA) for its last fiscal year: Total liabilities and shareholders’ funds 30,000; current liabilities 8,000; short-term loans 2,000; short-term lease bonds 1,000; long-term loans 5,000; long-term lease obligation 2,000; non-current liabilities 10,000; shareholders’ fund 12,000; cash and cash equivalents 2,000.
Rate of endettement
It is calculated by dividing a company’s debt by the funds of its shareholders. Lower the DE ratio, the better the creditworthiness of an entity. Debt can be narrowly defined by considering only long-term borrowing. For HA, long-term equity borrowings are 0.42 times. If its long-term equity borrowings for the previous year were 0.54 times, then the company has improved its solvency position for the current year.
Alternatively, we can think of debt as the sum of long-term loans and long-term rental obligations. For HA, the modified debt to equity is 0.58 times (sum of long term loans of Rs 5,000 crore and long term lease obligations of Rs 2,000 crore divided by shareholders’ funds of Rs 12,000 crore). If its figure for the previous year was 0.56 times, then the company has lost its solvency for the current year.
We can define debt as the total of non-current liabilities. For HA, the modified debt to equity is 0.83 times (non-current liability of Rs 10,000 crore divided by equity of Rs 12,000 crore). If its figure for the previous year was 0.96 times, then the company has improved its solvency position for the current year. The broader definition of debt may include (in addition to the above) either short-term borrowings, the sum of short-term borrowings and short-term lease obligations or all current liabilities. Since the investor is interested in the margin of safety regardless of the time horizon, it is prudent to view debt as the sum of long-term borrowings, long-term lease obligations, short-term borrowings. term and short term rental obligations. Therefore, the modified DE for HA is 0.83 times (sum of LTB of Rs 5,000 crore, STB of Rs 2,000 crore, LT lease obligations of Rs 2,000 crore and ST lease obligations of Rs 1,000 crore divided by shareholders’ funds of Rs 12,000 crore). If its figure for the previous year was 0.92, then the company has improved its solvency positions for the current year.
Some may define debt as the excess of the sum of LTB, STB, long-term lease obligations and short-term lease obligations over cash and cash equivalents. This is called net debt. Net DE is calculated by dividing net debt by equity. For HA, it is 0.67 times. If its figure for the previous year was 0.71, then the company has improved its solvency position for the current year.
We can use the last two variations because they are broader, conservative and intuitive to measure the solvency position. Alternatively, we can consider the market value of equity in the denominator to calculate the market DE ratio.
The writer is Associate Professor of Finance at XLRI – Xavier School of Management, Jamshedpur