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UNDERSTANDING SOME LEVERAGE RATIOS

A high level of debt used in funding the operations can be risky for the business, especially in an economic downturn when revenues and profitability reduce. Leverage Ratios can be used to analyse the extent of leverage used by a business and its ability to meet the obligations arising from them. Some of these important ratios are as under:

Debt-Equity Ratio (D/E): High levels of debt in a business can prove to be detrimental for a company. In absence of its ability to pay to the lenders, business may have to face bankruptcy. When businesses create assets aggressively out of borrowed money, it could be quite dangerous if the assets are unable to generate the expected revenues and profitability. The liability will still have to be met.

It would be prudent for investors to avoid companies with extremely high levels of debt. On a most conservative basis, a D/E of 1 or less should be considered as the benchmark, and then depending upon the industry, track record of the company, capital required, project details, should a decision be taken.  This ratio is defined as:

D/E Ratio = Long Term Debt / Net-worth

Interest Coverage Ratio: Companies having high debt need to pay high interest as well. Whether a company is headed for a trouble can be simply seen by comparing its earnings with the interest. This ratio, popularly known as Interest Coverage Ratio, tells us how many times the earnings of the business is, with regard to its interest obligation. This is simply defined as: 

Interest Coverage Ratio = EBIT / Interest Expense

If this ratio is high, clearly, business is in comfortable zone. The ratio will be less than one or negative in some businesses, which means that earnings are less than interest or earnings are negative and interest obligations exist. As these businesses would be either borrowing money or infusing equity to run the show, these businesses may come into significant problems if they don’t turn around soon.

Debt Service Coverage Ratio (DSCR): The debt service coverage ratio (DCSR) is used in corporate finance to measure the amount of a company's cash flow that's available to pay its current debt payments or obligations. The DSCR compares a company's operating income with the various debt obligations due in the next year including lease, interest, and principal payments. This ratio is defined as:

DSCR = Net Operating Income / Total Debt Service

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