Chapter 17 · Debt Analysis
How much debt is too much
There is no universal answer, but there is a way to work out the answer for a specific company.
Debt is not bad. It is cheaper than equity, the interest is tax-deductible, and used sensibly it raises returns for shareholders. It becomes dangerous for one reason: interest must be paid whatever happens, while profits vary.
| Measure | Formula |
|---|---|
| Gross debt | Long-term debt + Short-term debt |
| Net debt | Gross debt − Cash and equivalents |
| Debt to equity | Total debt ÷ Equity |
| Net debt to EBITDA | Net debt ÷ EBITDA |
| Interest coverage | EBIT ÷ Interest expense |
| Debt service coverage | Operating cash flow ÷ (Interest + Principal due) |
Debt service coverage, and why it is stricter
Interest coverage only asks whether profit covers interest. Debt service coverage asks whether cash covers interest and the principal falling due. A company can pass the first and fail the second — and it is the second that causes defaults.
Worked: operating cash flow Rs 1,20,00,000; interest Rs 25,00,000; principal repayment due Rs 45,00,000.
- Interest coverage (on EBIT 1,00,00,000) = 4.0 — looks fine
- Debt service coverage = 1,20,00,000 ÷ (25,00,000 + 45,00,000) = 1.71 — adequate but far tighter
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