NSE IFSC – Debt to equity ratio

1. NSEIFSC Debtto equity ratio

2. 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 forprofitandleastprobabilityofrisk.Suchevaluationiscarriedoutthrough FundamentalAnalysis.FundamentalAnalysisinvolvesevaluatingthecompany’s financialstatusbystudyingitsBalanceSheet,IncomeStatement(alsocalledProfitand Loss Statement), Cash Flow Statement, and its Financial Ratios. Out of these, Financial Ratioshelpuscomparetwoor morefinancialparametersofthecompanyto understand its financial status better. Using these ratios, you can understand the company’sfinancialhealthandalsocomparethecompanytoitspeersthatoperatein the same industry or sector. One such parameter is Debt to Equity Ratio. In this blog, wewillfindoutmoreaboutDebttoEquityRatioandthedebttoequityratioformula.

3. DebtandEquity 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. DebtFinancingisessentiallyborrowingmoneyfromacreditorbytakingaloanatafixed 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 earningspershareofexistingshareholders,andisatimeconsumingprocess. Debtfinancinginvolvesonlyinterest paymentsastheprimarycost.Thiscanbe deductedfromtheiroveralltaxliability andthusmakesitthepreferredformof 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 withnochoicebuttodeclareitasanon-performingasset.

4. DebttoEquityRatioFormulaandHowtoInterpretIt Now,letusunderstandwhatisDebttoEquityRatioandhowitiscalculated. As the name suggests, this financial ratio calculates the company’s total debt versus the equity. Calculating and evaluating the Debt to Equity Ratio tells investors how much of the company’s assets are debt financed. This would aid them in measuring creditriskincasethecompanyisliquidated. Debt to Equity Ratio is also known as Gearing Ratio or Risk Ratio. It comes under LeverageRatiosorSolvencyRatios.Theseratioshelpanalystscomparethedebtlevel ofacompanytoitsequityandassets.Thisallowsthemtounderstandthecompany’s abilitytomeetitslongtermdebtobligations.

5. DebttoEquityratioiscalculatedbydividingtotalliabilitiesofthecompanybyits shareholders’equity.

6. Where, Total Liabilities refers to long-term debt with a minimum maturity period of more than fiveyears.Itisanon-currentliabilityandisnotthesameasshort-termdebtwhichmustberepaid withinfiveyears. QuickRatioorCurrentRatiowouldbebettersuitedtounderstandthecompany’sabilitytorepay itsshort-termdebtsorliabilities. As Debt to Equity Ratio calculates whether the company can repay its long-term debt, we can deducethatahighvalueforthisratiowouldnotbeafavourablesign.Ahighdebttoequityratio wouldsignifythatthecompanydoesnothaveenoughequitytorepayitsdebtsandthusmakesit 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. AcompanywithaDebttoEquityRatioof1:1isconsideredtobesaferasthecompanyhasequal 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 comparedtoitsequity.

7. IdealDebttoEquityRatio 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 idealdebttoequityratioforacompanyaidsusinassessingthecompanycorrectly. Somecompaniesmayhave negativedebttoequity ratios.Itsignifiesthatthecompany 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 equityratioof-0.25. Somecompanieshavealoworzerodebttoequityratio.Generally,theseareconsidered 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 expanditsbusinessandincreaseitsprofitsbytakingdebt.Attimes,thecompanycould have low debt to equity ratio but not perform well in other aspects, making it a bad investment.

8. 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 financialsectortypicallyhavehighdebttoequityratiowhilealsobeinggoodavenuesfor investment. This makes it necessary to consider the average debt to equity ratio of the industrybeforemakingadecision. The interest Coverage Ratio is an important financial parameter that can help us make thefinaldecisionincaseofcompanieshavingahighdebttoequityratio.Thisratiotells us about the company’s 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 paymentsandarenotgoodinvestments.

9. ImplicationsofHighDebttoEquityRatio A high debt to equity ratio indicates several factors about the company. We shalldiscusstheminthissegment. Reduction in Equity Ownership: A high debt to equity ratio signifies that shareholders’ equity is less and thus they have lower claim on the company’s earningsandassetsascomparedtothelendersandcreditors.Thisalsomeans that a large portion of the earnings is used for debt servicing, reducing the earningspersharefortheshareholders.

10. LimitationsofDebttoEquityRatio Themostcommonmistakemadebyinvestorswhenconsideringthedebttoequity ratio of the company is not checking the industry standard. As different industries havedifferentcapitalrequirementsanddifferenttimeframesfor growth,adebtto equity ratio levels for each industry are different. To rectify this error, we must comparetheratiowiththelevelfortherestofthecompaniesoperatinginthesame industry. Furthermore,whileDebttoEquityRatioisagoodparametertoassessthefinancial healthofthecompany,wemustalsoremembertocheckotherfinancialratiosofthe company before making our investment decisions. At the very least, an investor mustcheckwhetherthecompanyhasagoodreturnonequitybeforeinvesting.