9.14 Capital structure ratios

Hanumant Dhokle

Ratio Analysis

These ratios would make you understand the use of debt and equity in the company’s capital employed.

(a) Debt-Equity Ratio:

This is defined as

Total Loan Funds
--------------------------------
Net Worth


Referring to the Tata Motors’ balance sheet, try to calculate the debt to equity ratio of the company for 2002-03.

Note that some analysts define this rate as Total Liability - Net Worth/Net Worth.

(b) Interest Coverage Ratio:

This will reveal to you how many times the interest payment has been covered by the earnings before interest.

It is defined as

Profit before Interest and Tax
----------------------------------------------
Interest


For TISCO, the interest coverage ratio would be (2,132.91/342.41) = 6.22

How important is capital structure ratio?

Debt-equity ratio is one of the most important tools for analysts owing to the following:

  1. Ideally speaking, the debt-equity ratios between 1:1 to 1.3:1 are better for companies. If the ratio is too high it means that the company is borrowing heavily, thereby resulting in higher interest cost. This squeezes its profits.
  2. If the debt-equity ratio is too low (which happens mostly for large companies), it indicates that the company is using too much of equity funds instead of borrowing. This is not good for the investors because the EPS gets diluted with an increase in equity capital.
  3. Long-term debt-equity ratio is an excellent tool for predicting rights shares. As per the norms of the financial institutions, currently most of the companies are not allowed to keep a long-term debt-equity ratio of 1.5: 1. So, if the current long-term debt-equity ratio is above 1.5, and the company has an expansion/diversification plan, it must do so by partly increasing its equity. Or else financial institutions would not offer the company loans. In such a case you may expect a rights’ issue.
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