The analysis of a company’s financial ratios is core to the scrutinizing process of banks as these ratios help understand a company’s overall financial risk profile. These parameters are:-
A company's capital structure - commonly referred to as gearing, leverage or debt to equity ratio - reflects the extent of borrowed funds in the company’s funding mix. The equity component in the capital employed by a company has no fixed repayment obligation; returns to equity shareholders depend on the profits made by the company. Debt, on the other hand, carries specified contractual obligations of interest and principal. These will necessarily have to be honoured, in full and on time, irrespective of the volatility witnessed in the business.
Interest Coverage Ratio
Interest coverage represents the extent of cushion that a company has for meeting its interest obligations from surplus generated from its operations. The ICR, therefore, links a company’s interest and finance charges to its ability to service them from the profits generated from operations. Thus, companies with a higher interest coverage ratio can absorb more adversity and are more likely to pay interest on time; therefore, they are theoretically less likely to default. For business that have an intrinsically low profit margin , a high interest burden – either on account of high gearing or high cost of funds, or both - may adversely affect the interest coverage ratio.
Interest & finance charges refer to the total interest payable by the company during the financial year under assessment. It includes the interest component of lease liabilities, non-funded capitalised interest and also preference dividend. (Some companies also use EBIT in the numerator)
Debt Service Coverage Ratio
The DSCR indicates a company’s ability to service its debt obligations, both principal & interest, through earnings generated from its operations. Debt payable within one year primarily constitutes the present portion of long term debt (the portion of long term debt that is slated to mature during the ongoing year) and short -term debt obligations (debt that has an original tenure of less than one year)
It is a very important ratio used extensively by lenders to check if the borrower company has sufficient cash flow to pay the instalment of the debt. Many a times, decision for extending term loan depends on this ratio.
A company in need of long term loan prepares projections for future periods to assess the viability of the project. The lenders are interested in the period for which they are extending loan. For example, a term loan is to be sanctioned for 10 years. The DSCR for each of these 10 years will be calculated and all of them should be more than '1' at least.
Generally speaking, higher the ratio better it is. Mostly DSCR between '1.25 to 2' is considered good and satisfactory. Why we need DSCR of more than '1', because it is calculated based on the projections. There is always a risk of projections not turning correct. It is understood that anything above ‘1’ increases the possibility of payment by the borrower. Norms for ideal DSCR may varies with different countries, different types of loans, different industries etc.
Too high a DSCR means the company can borrow more money but it is not borrowing. In other words, the potential benefit of leverage due to debt proportion in capital structure is not taken. Higher debt in the capital structure brings down the overall cost of capital because debt is the cheaper source of capital for a business.
A company's net worth represents shareholder’s funds that do not have fixed repayment or servicing obligations, thus provides a cushion against adverse business conditions. The tangible net worth represents the true equity that is available for absorbing losses or temporary financial problems. A company’s net worth is reflection of its size thus; net worth constitutes an important parameter in credit risk assessment. A large net worth usually reflects the company’s strong market position and economies of scale; it also enhances financial flexibility, including the company’s ability to access capital markets. A strongly capitalised company will thus be more resilient to economic downturns.