How much debt is too much debt?

In this post, we discuss how to evaluate the debt situation of a business.

Leverage is a two-way sword. Use it right and it can amplify returns on capital. Use too much of it and it can blow up. It's very difficult to ascertain an ideal proportion of debt in the capital structure but it can be assessed if it's beyond manageable and net negative for the business. Let's check how we can evaluate the debt situation of a business.

Start with the basics

Gearing ratios: Debt / Equity and Debt / Assets

These ratios reflect how aggressive or conservative the capital structure is. Typically Debt / Equity ratio of 1:1 is considered to be the threshold of maximum leverage. In other words, if total assets are financed more by debt than equity, it's generally not a good sign. By the way, be conservative and consider total debt (not only the long term in nature) in the numerator. However, these ratios don't tell much beyond the mix of capital structure. To make more sense of the situation, these ratios should be used with coverage ratios.

Interest Coverage and Debt Service Coverage Ratio (DSCR)

Interest coverage and DSCR are among the most important metrics to assess the creditworthiness of a borrower for financial institutions.

Interest coverage - Earnings before interest and taxes (EBIT) / interest DSCR - (PAT + Depreciation + Other non-cash expenses) / (Principal + Interest)

These ratios tell us whether the profitability of a business is sufficient to cover its debt obligations. Thus higher these ratios, the better. In India, RBI prescribes the DSCR of 1x or more for the borrowers. However, a DSCR of close to 1x can be tricky as it means that the cash accruals from the business are just enough to service the debt obligations. It doesn't leave much room for variation in profitability or additional leverage. Thus DSCR of 2x or more is preferable.

Debt / EBITDA and Net Debt / EBITDA

In coverage ratios, profitability is in the numerator and the debt component is in the denominator. In these ratios, profitability is in the denominator which reflects the pay-off period for debt with present profitability. Typically, as per RBI guidance, lenders prefer Debt / EBITDA of less than 4x. Net Debt / EBITDA goes one step ahead as it deducts cash and cash equivalents from the total debt to arrive at the net debt figure. Again, there is no prescribed standard Net Debt / EBITDA level but 3.5x or less is preferable.

All of the above ratios consider profitability to assess a business's capacity to repay its debt obligations. However, there can be a situation where profitability is good but cash flows are not sufficient to service the debt. Because let's face it. Interest and principal need to be paid out of cash generated by operations. Hence, the below ratio should be a part of the metrics to judge the debt situation of the business.

Cash Flow from Operations / (Principal + Interest)

The above should be evaluated in conjunction with each other. Furthermore, these ratios vary from industry to industry. However, trends are useful in the assessment. Usually, deterioration in trends is an important sign of potential blow-up in near future.

"Leverage magnifies outcomes but doesn’t add value" - Howard Marks

Important considerations

Type of debt

It's important to understand the debt structure. Long-term debt includes term loans from the banks, corporate bonds, debentures, etc. Usually, term loans from the banks are callable on demand and hence the business should have sufficient liquidity to repay the entire debt when called. There are additional considerations such as Forex fluctuations in the case of foreign currency-denominated debt.

Terms and conditions

Long-term debt often comes with various covenants and conditions from the lenders (more so in the case of term loans) which place certain restrictions on the borrower. Further, security pledged/hypothecated for long-term debt is also an important consideration. Finally, the interest rate (fixed or variable) and the period for which the long-term debt is taken should be reviewed. The above aspects reflect the firm's negotiation power with the lenders.

Short-term vs. long-term debt

In India, RBI guidelines prohibit financing long-term projects through short-term facilities. Short-term debt should be represented by inventories and receivables. If it's not the case, it should be checked where the company is deploying short-term borrowings. A common-size balance sheet provides a clue in this regard.

Companies take short-term debt for working capital requirements and long-term debt to fund Capex projects. The debt-funded projects should result in assets that enhance the income generation capacity of the business. Non-income generating assets should not be indirectly represented by debt. It's a double whammy for shareholders when the wrong capital allocation decision meets high leverage. Prudence is the key!

Cost of debt vs. RoA

Finally, the cost of debt should be less than Return on Assets (RoA). Consider this. The debt on the liabilities side is represented by assets that are subject to depreciation while the debt requires interest servicing. Hence, the assets that are created with the debt must generate profitability much higher than the cost of debt. Otherwise, return ratios (RoE and RoCE) are adversely impacted.