Liquidity and Solvency
Solvency Ratios help investors evaluate the competence of a company to meet its long term debt obligations. Liquidity Ratios are used to evaluate the ability to pay off short term debt obligations.
The Debt to Equity ratio tells us how much a company’s debt weighs against its shareholders equity. It gives us an overview of a company’s capital structure by measuring the amount of employed debt against equity.
The Debt to Equity ratio can be defined as
Debt to Equity Ratio = Total Debt / Shareholders Equity
We’ll consider total debt as the sum of financial obligations which bear interest and lease liabilities. This includes current and non-current borrowings, lease liabilities, current maturities of long term debt and lease obligations, and any other liabilities that can bear interest. We will NOT consider trade payables, provisions, and deferred tax liabilities for calculating the total debt. Keeping this in mind, we can define total debt as,
Total Debt = Current Borrowings + Non-current Borrowings + Lease Liabilities + Current Maturities of Long Term Debt and Lease Liabilities + Other Interest Bearing Obligations
We can also restrict total debt to non-current borrowings and other interest bearing non-current financial obligations only depending upon the company we’re analyzing. In such cases, we’re primarily concerned with the non-current financial obligations of the company in comparison to the shareholders equity.
We’ve already defined shareholders equity before as total assets minus total liabilities. It can also be found on the balance sheet in an annual report.
Part 2 of the Balance Sheet of Larsen & Toubro Ltd for the financial year 2020
Let’s consider the balance sheet of an infrastructure and construction company — Larsen & Toubro.
The total debt can be calculated as
₹35,021.02 + ₹23,654.77 + ₹82,331.33 + ₹1,741.6 + ₹424.95 = ₹1,43,173 crores. The Shareholders Equity is
₹280.78 + ₹66,442.44 + ₹9,520.83 = ₹76,244.05 crores. This gives us a debt to equity ratio of
₹1,43,173 / ₹76,244.05 = 1.87.
A debt to equity ratio of
1.87tells us that for every ₹1 in shareholders equity, Larsen & Toubro has
Usually, a higher value of debt to equity ratio indicates higher insolvency risk compared to another company with a lower value. Although this may be correct but the assumption that comes attached — a company with a higher debt to equity ratio is unequivocally not going to stay solvent - isn’t always true. This is because a company’s financial ability to cater to its debt obligations needn’t be stuck solely in shareholder’s equity.
As we’ve said before, ratios are meaningless when looked at in isolation. Let’s calculate the debt to equity ratio of another construction company, Reliance Infrastructure Ltd.
Part 2 of the Balance Sheet of Reliance Infrastructure Ltd for the financial year 2020
Note 11(d) of the financial statements of Reliance Infrastructure for the financial year 2020
We’ve showcased Note 11(d) from Reliance Infra’s financial statements because it contains figures for the premium payable to National Highways Authority of India (NHAI). According to this ET article, NHAI premiums are payments made by construction companies to NHAI in build, operate, and transfer (BOT) projects. We’re considering NHAI premiums as a component of total debt.
The total debt can be calculated as
₹11,758.86 + ₹2,541.37 + ₹2,765.28 + (₹272.31 + ₹2,206.92) + ₹13.98 + ₹67.61 = ₹19,626.33
and the shareholders equity is
₹11,621.82 croreswhich gives us a debt to equity ratio of
Note that comparing the debt to equity ratio of companies from different sectors or industries isn’t helpful and often misleading. Simply put, different sectors, or industries, have different operational and financial aspects. IT companies are generally cash rich and don’t require a lot of capital compared to construction companies so it makes sense that the debt to equity ratio of IT companies would be lower than that of banks & non-banking financial companies (NBFCs) whose business model depends entirely on borrowing money from one entity and loaning it to another.
Another thing to keep in mind is that companies at different stages of their business cycle may have varied debt to equity ratios, so comparing their values may not be perfectly intuitive. One company may be in its expansion stage while another may be focusing on winding down its debt. Companies of different scales may also yield varied debt to equity ratios. This is because cost of debt is often dependent on a company’s size and can affect a company’s decision to take on more or less debt.