Companies usually look at two options - debt and equity when they need to raise money. While money raised from equity does not attract interest, raising capital via equity issue could be a long and complex process. . However, raising funds via debt allows these companies to raise money without diluting any equity with them.

Majority of the companies raise money on debt via bond issuance. An analysis of a company’s debt servicing capacity is therefore an important parameter for investors to decide whether they should or shouldn’t participate in the bond issuance by any company.

In this article, let us look at ways in which a company or an investor can analyse a company’s ability to service their debt.

Interest Coverage Ratio:

Interest Coverage Ratio is a parameter used to determine whether a company has earned enough money throughout a given duration to pay off its interest costs. It’s calculated by dividing interest expense by EBIT, which is derived after subtracting all the expenses, except the interest and tax payments, of the company from its income. In short, Interest Coverage Ratio checks whether a company, after paying all its total expenses including depreciation & amortization costs has money to pay the interest expense or not. Interest Coverage Ratio can be calculated by dividing the company’s earnings before interest and taxes (EBIT) by its interest expense during a given period by the company’s interest payments due within the same period.

Interest Coverage Ratio= EBIT / Interest Expense

where EBIT = Earnings before Interest and Tax

If the ratio is greater than 1, then the company can service its debt from its profit. If the ratio is less than 1, it implies that the company can not service the debt from its profit as on given date. However, there might be a case wherein the company has raised money through debt for a project that would bear fruits in the next financial year. So, though interest coverage ratio is an important factor, the investor should evaluate it along with other parameters to decide whether or not to invest in the company.

Debt Ratio:

This is a very important parameter for ​lenders to understand whether the company they are lending to will be able to pay them their money back. If the company has excessive debt then it is at a very serious risk of default. Investors may want to be informed about the company’s debt ratio as they may want to be assured that the company they will be investing in is worth their investment.

The formula for calculating debt ratio is

Debt Ratio = Total Liabilities/ Total assets.

If the ratio is very high, the company doesn't have enough assets to cover the liability, whereas, if the ratio is low, the company could service the debt by selling off all the assets in the worst case scenario.

Debt to Equity Ratio

The debt to equity (D/E) ratio is another vital metric to assess the company’s financial health. The D/E ratio helps in understanding the degree to which a company’s operations are financed through debt or wholly-owned funds. This helps in reflecting whether funds from equity can cover all outstanding debts in the event of a fall out in business.

The formula for calculating Debt to Equity ratio is

Debt to Equity ratio = Total Liabilities / Equity

If the ratio has been increasing, then it implies that the company's profits may not be enough to sustain its growth plan and the growth is riding on the back of borrowings.

Current Ratio

This ratio helps in measuring a company’s ability to pay short-term obligations. This metric helps investors analyse how a company can pay short term debt with its current assets.

For calculating the ratio, the company’s current assets are divided by its current liabilities. Current assets listed on a company's balance sheet account for cash, accounts receivable, inventory and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt.

Current Ratio : Current Assets/ Current Liabilities

If the ratio > 1, then the company will not default on current liabilities, whereas, if the ratio < 1, then there are high chances that the company will default on short term borrowings, thereby pushing the company towards the possibility of credit rating downgrade.

To sum it up, evaluating the debt servicing capability of a company before investing is crucial to help understand the financial health of a company and its ability to weather economic headwinds.