Using Debt Equity ratio for investing decision

Debt to Equity, or simply Debt-Equity ratio is a ratio to identify highly leveraged companies. Companies with disproportionately high debts carry greater risk of bankruptcy and D/E ratio is an important place to start the investigation. D/E tells what portion of company’s business is financed by shareholders’ money, and what portion is financed by the money from lenders. It is important to know the obligation shareholders of the company may have to bear in the event the business is not able to repay the debt. This becomes particularly important in the event of economic downtrend, when the company may fail to meet its financial obligations because of low profitability. Higher debt may create liquidity crunch, when the repayment falls due. It may also be a drain on company’s income, since interest needs to be serviced in a timely manner. Sustained period of low income or losses may lead a highly leveraged company to bankruptcy.

A low D/E ratio denotes that a higher portion of company’s business is financed by the shareholders’ money, whereas a high D/E ratio means that a higher portion of funding comes from debts.

Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity

This ratio is easy to compute from the balance sheet of a company. Let us take an example.

Here is the liabilities side of the balance sheet of Sun Pharmaceuticals Limited for the year ended 31st March 2018

EQUITIES AND LIABILITIES Rs Crores
SHAREHOLDER’S FUNDS  
Equity Share Capital 239.93
Total Share Capital 239.93
Reserves and Surplus 19,530.17
Total Reserves and Surplus 19,530.17
Total Shareholders Funds 19,770.10
Equity Share Application Money 0
Share Capital Suspense 0
NON-CURRENT LIABILITIES  
Long Term Borrowings 1,564.69
Deferred Tax Liabilities [Net] 0
Other Long Term Liabilities 0.91
Long Term Provisions 345.18
Total Non-Current Liabilities 1,910.78
CURRENT LIABILITIES  
Short Term Borrowings 5,213.81
Trade Payables 2,489.94
Other Current Liabilities 2,114.25
Short Term Provisions 2,425.49
Total Current Liabilities 12,243.49
Total Capital And Liabilities 33,924.37

Total shareholders Funds are Rs 19,770 crores. Total liabilities are Rs 14, 153 crores (sum of non-current and current liabilities).

D/E Ratio is Rs. 14,153 crores / Rs. 19, 770 crores = 0.72

And you thought accounting ratios were difficult to compute!

This means Sun Pharmaceuticals has a debt of 72 paisa against Re 1 of equity. In the worst case scenario, theoretically speaking, if debt was required to be paid out of shareholders’ money, the company has money to pay it, and th company will be left with 28 paisa to the rupee, or 28% of shareholders ‘ equity after meeting the liabilities of the outsiders.

Is debt bad for a company?

A company may finance its operations out of debts or equity. The choice is a strategic management decision and has an impact on the profitability of the business. Debt per se may not be bad, as we explain here.

  1. Sometimes equity is not the best option. The company may sometimes need funds for a short term; equity is a long term commitment. If a project has a short payback period, it makes sense to fund it by debt and repay the debt out of the profitability, than increase the equity which remains with the company forever and needs to be serviced.
  2. Equity is expensive. Shareholder takes higher risk when he invests in a business, so his expectation of return is also higher, debt is cheaper.
  3. Debt lets a company expand a business without diluting the owners’ stake. Return to shareholders is likely to be higher in case of profit making companies which uses debts as a means of financing. For example, a company has a 20% return on investments, if it borrows @9%pm, the return to the shareholders will increase because the cost of additional capital is lower than the rate of return on investments.
  4. Taxation is one of the most important, but often ignored, factors in calculating cost of funding. If the cost of servicing a debt as well as equity is same, it still makes debt cheaper, thanks to the impact of taxation. Let us explain:

Let us presume the cost of borrowing and equity funding is same, on a fund of Rs 10 crores the company pays Rs 1 crore per annum.

In case of debts, the amount of interest paid is tax deductible. The present rate of taxation in India is around 30%, on an interest payout of Rs. 1 crore the company saves Rs. 30 lakhs on taxes. In case of shares on the other hand, there is a tax to be paid by the company (from its own funds) before it pays out dividends, known quite interestingly as DDT (Dividend distribution tax). The present rate of DDT is around 17.5%. This works out to a tax rate of 21%, to pay Rs 100, you need Rs 121, pay 17.5% of that (Rs. 21) to get Rs. 100. Thus, the cost of capital in the two cases will be as under:

DEBT                                                             EQUITY

INTEREST/DIVIDENDS        Rs. 1 crore                                             Rs. 1 crore

Tax saved                             – 0.30 crore                                            0

DDT paid                                    0                                                +0.21 crore

Total Cost                              0.70 crore                                          1.21 crore

You can now see what difference the share of the hidden partner- the Govt. Of India- can make to the cost of capital.

Having convinced you that debt is good; let me proceed to tell you that debt is not all that good. It comes with its share of hazards. Let me list out arguments in support of this:

  1. Cost of servicing a debt is a fixed charge, it has to be paid, come what may. Profit or no profit debt must be serviced. The shareholder is a risk taker; he knows that if the company does not make money, he gets no return.
  2. The advantage of leverage works backwards when the business goes down. When profitability is low, or there is a loss, interest becomes another burden to handle. The tax benefit explained above ceases to be an advantage, since there is no tax being paid by a loss making company.
  3. Lenders are usually fair weather friends, they would lend to you when the going is good, if it turns bad, they withdraw the money in the first opportunity, making the sinking ship sinking faster.

The verdict

Debt equity mix is a matter of choice for the company management. The macro environment also plays a role. Some industries like infrastructure might need larger debts when handling high value projects, companies in FMCG space has a linear business pattern and may not need much debt. For some companies, debt-equity is not a choice; they tap either of the two that is available to them.

From the investors’ perspective, a high debt is to be avoided. Some investors consider a debt equity ratio of 1.5:1 to be the maximum limit, that is a debt of Rs 1.5 for every rupee of own funds; some investors would consider anything beyond 1:1 to be risky. Some extremely cautious investors would look for a much lower number. Investors like Warren Buffett look for companies that have near zero interest burden. While there are advantages in having debts as explained above, I also subscribe to the Buffett like caution, I filter out leveraged companies from my list, however attractive they may look otherwise.

©Dr. Tejinder Singh Rawal

Chartered Accountant

M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD

This content is copyrighted and no part of it may be reproduced without the consent of the author

 This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated

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