Debt-to-equity and net debt

In simple terms

Borrowing lets a company invest more than its shareholders' money alone would allow. Used carefully, it can raise returns, as the ROE lesson shows. But debt must be repaid and interest must be paid whatever happens to the business. Most corporate collapses involve debt that could not be serviced.

Analysts use a few simple measures to judge how much a company owes and whether it can cope.

Gross and net debt

Gross debt is all interest-bearing borrowings: bank loans, bonds, debentures, commercial paper, both long-term and short-term, including the part of long-term loans due within a year.

Net debt subtracts cash and liquid investments that could be used to repay it:

A company with more cash than debt has net cash. Net debt gives a fairer picture than gross debt for companies that hold large cash balances, but check that the cash is really available: cash held in another country, pledged to lenders, or needed for day-to-day operations cannot all be used to repay debt.

Debt-to-equity

A debt-to-equity of 0.5 means the company has borrowed 50 paise for every rupee of shareholders' equity. This measures financial structure: how much of the business is funded by lenders rather than owners.

Its weakness is that equity is a book value, which can be far from what the assets are worth or what they earn. A company with low debt-to-equity can still struggle if its profits are tiny.

Net debt to EBITDA

To judge repayment capacity, compare debt with earnings. EBITDA, earnings before interest, tax, depreciation and amortisation, is a rough measure of yearly operating cash earnings before investment.

A rough rule many analysts use is that net debt above about three times EBITDA deserves close attention for an ordinary industrial company, but there is no universal safe level, as the next section explains.

Leases and other debt-like items

Some obligations behave like debt even if they are not called borrowings.

• Lease liabilities. Under Ind AS, most long-term leases of property and equipment appear on the balance sheet as lease liabilities. For retailers, airlines and hotels these can be large.
• Guarantees for loans taken by subsidiaries or related companies.
• Unfunded pension obligations, deferred payments for acquisitions, and similar commitments.

When they are significant, include them in debt and use EBITDA consistently, because lease payments are excluded from EBITDA under these rules.

Why safe levels differ by industry

How much debt a company can carry depends on how stable and predictable its cash flows are.

• Stable businesses, such as regulated utilities or toll roads with long concessions, can safely carry more debt because their income is predictable.
• Cyclical businesses, such as steel, cement or airlines, should carry less, because their earnings can collapse in a downturn just when debt is hardest to service.
• Banks and lenders are financed mainly by deposits and borrowings; their debt is measured with different tools, covered in the analysing banks lesson.

Compare a company with its peers and with its own history, and look at the worst year of its last downturn: could it have serviced today's debt with that year's earnings?

When debt becomes dangerous

• Falling earnings: debt that was two times EBITDA becomes six times if EBITDA falls by two-thirds.
• Rising interest rates: floating-rate loans become more expensive.
• Refinancing: large loans falling due at a time when lenders are cautious.
• Currency mismatch: borrowing in foreign currency while earning in rupees.

The interest coverage lesson looks at the second half of the picture: whether profits comfortably cover the interest bill.

Why it matters

Debt magnifies outcomes. It can lift returns in good years, but in bad years it can force a company to sell assets cheaply, issue shares at low prices, or default, wiping out shareholders. Checking debt levels is one of the most important protective steps in analysing any company.

Limitations

Balance sheets show debt at a single date, which may be lower than the average during the year. EBITDA ignores capital expenditure and tax, so a company with high EBITDA but heavy investment needs may have less cash for debt repayment than the ratio suggests. And ratios do not show the timing of repayments; read the borrowings note for maturity dates and interest rates.

Common mistakes

• Ignoring short-term borrowings and the current portion of long-term debt.
• Assuming all cash can repay debt.
• Forgetting leases and guarantees.
• Judging debt without reference to the stability of earnings.
• Treating any debt as bad. Moderate debt at sensible terms can be healthy.

Try it yourself

Choose a listed company and use its latest annual report.

1. From the balance sheet and borrowings note, add up all short- and long-term borrowings and lease liabilities.
2. Subtract cash and liquid investments to get net debt.
3. Calculate net debt to equity and net debt to EBITDA.
4. Find when the largest loans fall due and at what interest rates.