Debt is best treated as the sum of long-term and short-term lenders and loans. In general, investors and debt investors need to assess the solvency position of their investment candidates.
In this case, it helps investors to understand the debt-to-equity (DE) ratio calculation and its assumptions. Hypothetical illustration Let us assume the following figures (in crores) for the latest financial year of Hrishikesh Anand Limited (HA): Liabilities and Shareholders’ Funds 30,000; Current liabilities 8,000; Short-term loans 2,000; Short-term lease liabilities 1,000; Long-term loans 5,000; Long-term lease liability 2,000; Non-existent liabilities 10,000; Shareholders’ fund 12,000; 2,000 in cash and cash equivalent.
Debt-to-equity ratio It is calculated by dividing a firm’s debt by the funds of its shareholders. The lower the DE ratio, the better the solvency position of an entity. One can define debt briefly by considering only long-term loans. For HA, the long-term debt to equity is 0.42 times.
The company has improved its solvency position in the current year, from 0.54 times the long-term debt to equity in the previous year. Alternatively, debt can be calculated as the sum of long-term loans and long-term lenders. For HA, the revised debt to equity is 0.58 times (splitting the share of long-term loans of Rs 5,000 crore and long-term leases of Rs 2,000 crore into shareholder funds of Rs 12,000 crore).
The company’s solvency position fell to 0.56 times the previous year. Non-current liabilities We can define debt as total existing alternate liabilities. For HA, the revised debt to equity is 0.83 times (current liabilities of Rs 10,000 crore divided by shareholders’ funds to Rs 12,000 crore).
The company has improved its solvency position in the current year, from 0.96 times in the previous year. The broader definition of debt (in addition to the above) may include short-term loans or the sum of short-term loans, short-term liabilities, or all existing liabilities. Since the investor is interested in the security margin regardless of the time horizon, it is prudent to calculate debt as a sum of long-term loans, long-term lenders, short-term loans, and short-term lenders.
Therefore, the revised DE for HA is 0.83 times (divided into Rs 12,000 crore shareholder funds, including Rs 5,000 crore LTB, Rs 2,000 crore STB, Rs 2,000 crore LT lease liability and ST lease liability Rs 1,000 crore). The company has improved its solvency positions in the current year from 0.92 in the previous year. Some may define debt more than LTB, STB, long-term leases, and short-term leases equivalent to cash and cash equivalents. This is known as net debt.
Net DE is calculated by dividing net debt by equity. For HA it is 0.67 times. The company’s solvency position improved in the current year from 0.71 in the previous year. Let us go through the last two variants because these are broad, conservative, and intuitive in measuring solvency position. Alternatively, the market value of the equity in the denominator can be considered to calculate the market DE ratio.