Why debt ratio of companies matters

While taking any investment decision, it is important to gauge the quantum of risk involved in treading an investment path. If the decision is to park money in a company by buying its shares, then an investor should have a ringside view of the entity’s risk and its earning capacity.

When it comes to assessing the risk and earning pattern, how a company uses its leverage should be kept under the lens. It could be handy if an investor makes an in-depth analysis of the expanse of a firm’s leverage.

What is leverage The general meaning of leverage is “a means to accomplish something”. This same connotation is applicable when it comes to finance too. In the world of finance, leverage means the ratio of debt to equity, or use of debt to increase the earning potential of the shares.

In other words, leverage is a process used to denote the use of fixed cost assets to increase the returns of the equity holders — the owners of the company. There are two leverages — financial leverage and operating leverage.

Effect of leverage It may be noted that by employing an asset or source of funds, the entity will have to pay a fixed cost that can have a ripple effect on the earnings of the equity shareholders. So, when an investor is looking to invest in a company, the leveraging factor should be taken into consideration.

A company has a positive leverage if its earnings are more than what the debt should cost. It is viable to buy shares of these companies as the firm has the financial muscle as far as leveraging is concerned. Moreover, the earnings per share (EPS) of these firms and the return on capital of these companies will be higher to the advantage of the shareholders. Buy shares of companies with positive leverage while planning an equity investment portfolio.

On the contrary, if an entity’s earnings fall short of the debt cost, then the company is on shaky grounds and the quantum of leverage is unfavourable. In this case, EPS and return on capital will decrease. So, keep away from such companies. The impact of leverage can be gauged by the variations in the EPS and return on capital.

Leverage and risk It is a known fact that investment in equities are fra-ught with risk. But the flip-side is that higher risk brings higher returns if the risks are taken in a mature and calculated manner.

The credo in relation to leverage is quite simple: When leverage is higher, the volatility of the company increases, resulting in higher risk. But higher risk can bring better returns to the owner in keeping with the principle that higher risk results in better returns.

The financial risk through leverage arises when a company depends too much on debt to run its operations, thereby increasing its financial obligations. Higher leverage in a company can also result in operating risk associated with the ratio of fixed cost in operations.

So while planning to invest in a company, you need to study its financial statements and find out the degree of cash flows.

Other factors to be considered Price-earnings (PE) ratio is one of the most popular and common yardstick used to zero in on the right stock. Current market value of a unit of stock divided by EPS will give the PE ratio. It is better to buy shares of a company with lower PE ratio.

Dividend payout ratio is another indicator that can guide an investor and can be arrived at by dividing total dividend by reported net income and multiplying it by 100. A stable dividend over a period of time is more desirable than a high or low ratio.

Price-to-book-value (PBV) ratio compares the price of a share with the company’s book value. A lower PBV means that the stocks are attractively priced.

Current ratio shows whether a firm has adequate current assets to cover its short-term obligations. The ratio is calculated by dividing total current assets by current liabilities. If the current ratio is between 1 and 2, it is advisable to invest in that company. If the ratio is less than one, the company or stock is better avoided when it comes to investment.

The writer is the CEO of BankBazaar.com