Liquidity, solvency and leverage ratios
The answer
A company does not fail because a ratio crossed a line. It fails on a specific date, when a specific payment is due and the money is not there.
So the useful work is not the debt-to-equity ratio. It is building net debt honestly, then reading the maturity table to find out when the payments fall due and what will pay them.
Why this costs you money
The current ratio, debt to equity and interest coverage are introduced in "Profitability and debt ratios". This article is about why those 3 numbers missed almost every corporate failure of the last 20 years.
Consider a company with a current ratio of 1.8, debt to equity of 0.6 and interest coverage of 4 times. Every one of those looks acceptable. Now add the facts the ratios did not contain.
- Two thirds of the debt matures within 11 months, and it was raised to fund a factory that will take 4 more years to generate cash.
- A large part of the short-term borrowing is commercial paper, which is unsecured short-term debt bought by mutual funds that can decline to renew it in a single afternoon.
- Interest coverage of 4 is calculated on operating profit. Cash interest paid is higher than the interest charged to profit, because interest on the factory under construction is being added to the asset instead.
- The current assets making the current ratio look fine are inventory and receivables, not cash.
Nothing above is unusual and nothing is hidden. The company is solvent on paper and can fail in a month. Liquidity is a question about dates and counterparties. Ratios that ignore both cannot answer it.
The second cost is the opposite error. Investors refuse companies with high debt to equity in industries where high leverage is normal and safe, such as regulated utilities with contracted revenue, or lenders, where borrowing is the raw material.
How it works
Building net debt so that it is actually net debt
Start with the balance sheet and then add 5 things from the notes.
Gross debt = non-current borrowings + current borrowings + current maturities of long-term debt
Then add:
Lease liabilities. After Ind AS 116 and ASC 842 these are on the balance sheet, and they are contractual obligations to pay money. Include them. Rating agencies do.
Acceptances and bills discounted. In India, supplier bills accepted by a bank on the company's behalf may sit in trade payables. Read the payables note. If a bank has paid the supplier, the company owes the bank.
Supply chain finance and channel financing balances, from article 6. Same logic.
Preference shares and perpetual instruments classified as equity. If they carry a compulsory dividend or a redemption date, they behave like debt whatever the balance sheet calls them. The instrument's terms are in the notes.
Receivables sold with recourse. If the company must repay the bank when the customer does not pay, the risk never left.
Then subtract cash and liquid investments, but only the part that is genuinely available. Article 6 covers restricted cash and cash trapped in subsidiaries.
Net debt = the total above − available cash and liquid investments
Finally, note separately, without adding it in: guarantees given to associates, joint ventures and related parties, from the contingent liabilities note. That is not debt. It is debt that becomes yours on somebody else's failure.
The measures worth calculating, in order of usefulness
1. Net debt to EBITDA. How many years of operating cash-like earnings the debt represents. This is the measure lenders and rating agencies actually use. There is no universal safe level. Stable, contracted businesses can carry 4 or more. Cyclical businesses are dangerous above 2, because EBITDA halves in a downturn and the ratio doubles without the debt changing.
2. The maturity ladder. How much debt is due in each of the next 5 years. Not a ratio. A table, and it is published.
3. Cash interest coverage.
Operating cash flow before interest and tax ÷ cash interest paid
Better than the usual earnings-based version for 2 reasons. It uses cash rather than profit, and cash interest paid includes interest capitalised into assets, which the profit-based version excludes.
4. Debt to equity. Last, not first. Book equity is an accumulation of historical accounting entries and can be negative for perfectly healthy companies. It is useful mainly for comparing companies within 1 industry with similar histories.
5. The current ratio. Weakest of all. It treats slow-moving inventory and doubtful receivables as though they were cash. The quick ratio, which removes inventory, is a small improvement. The cash conversion cycle from article 6 is better than both.
The maturity ladder, which is the real analysis
Both Indian and US filings disclose a table of contractual maturities of financial liabilities, usually inside the financial risk management note under the heading liquidity risk. It shows amounts due within 1 year, 1 to 3 years, 3 to 5 years and beyond.
Three questions to ask of it.
Does the maturity match the asset? Short-term borrowing funding a long-term asset is an asset-liability mismatch. It works until the lender declines to renew. Nearly every finance company failure in India and the United States has this structure at its centre.
How much is due in the next 12 months, compared with cash plus expected operating cash flow? If maturities exceed both, the company must refinance. It is not in trouble. It is dependent, and dependence is a condition, not a crisis.
Who are the lenders? Bank loans can be renegotiated in a room. Bonds held by thousands of investors cannot. Commercial paper held by mutual funds disappears fastest of all, because a fund manager facing redemptions declines to renew rather than making a credit decision.
Covenants, and a rule that catches people out
A covenant is a condition in a loan agreement. Typical ones require net debt to EBITDA below a level, or interest coverage above a level.
Breaching a covenant does not usually mean immediate repayment. It usually gives the lender the right to demand repayment, which is then negotiated.
Here is the accounting consequence that surprises investors. Under Ind AS 1, if a covenant is breached at the reporting date such that the lender could demand repayment within 12 months, the whole loan is reclassified from non-current to current, unless the lender agreed before the reporting date to give more time . So a covenant breach can move a large amount of debt from long-term to short-term on the balance sheet in 1 step, and the current ratio collapses overnight without any cash moving.
If you see current borrowings jump with no explanation in the debt note, look for a covenant breach.
Leverage in financial companies is a different subject
For a bank or a non-banking financial company, borrowing is the raw material, so debt-to-equity of 6 or 8 times can be entirely normal. Use different measures:
- Capital adequacy ratio, capital as a percentage of risk-weighted assets, with the tier 1 portion separately.
- Asset quality: gross and net non-performing assets, and the provision coverage ratio, which is how much has been set aside against bad loans.
- Liquidity coverage, which is high-quality liquid assets against 30 days of expected outflows.
- The funding mix: deposits are stickier than wholesale borrowing, and short-term wholesale borrowing is the least stable funding there is.
Debt that does not belong to the company but affects you
Pledged promoter shares. Promoters borrow personally and pledge shares of the company as security. If the price falls, the lender can sell. That selling pushes the price down further, which triggers more selling. The company's own balance sheet is untouched. Your holding is not. In India this is disclosed quarterly in the shareholding pattern.
What it tells you, and what it does not
It tells you whether the company can survive a bad year. That is the entire purpose. Solvency analysis is insurance analysis.
It tells you when the pressure arrives. The maturity table gives you dates.
It does not tell you the company will fail. Most leveraged companies refinance successfully for decades.
It does not price the risk. A leveraged company at a low enough price can be a better investment than a debt-free one at a high price.
It is a photograph of the year-end. For companies with seasonal working capital, or where borrowings are repaid just before the reporting date, the year-end number is the best of the year. Quarterly filings show the range.
The decision rule
Judge solvency by the maturity ladder against available cash and operating cash flow, not by a ratio. Then check where interest is classified and whether any interest is being capitalised.
If debt maturing within 12 months exceeds cash plus 1 year of operating cash flow, the company depends on somebody agreeing to refinance it — unless those maturities are working capital facilities that have rolled continuously for years with the same banks, in which case treat them as ongoing and watch the bank relationships instead.
Try this now
Five minutes, 1 holding. You are going to build the debt figure that your screener does not show.
- From the consolidated balance sheet, write down non-current borrowings, current borrowings, current maturities of long-term debt if shown separately, and lease liabilities, both current and non-current. Add them.
- Subtract cash and cash equivalents, other bank balances and current investments. That is your first net debt figure.
- Go to the financial risk management note and find the liquidity risk table showing contractual maturities. Write down the total due within 1 year. In a Form 10-K, use the debt note's schedule of maturities by year and the liquidity discussion in Item 7.
- Compare that 1-year figure with your cash from step 2 and with net cash from operating activities from the cash flow statement.
- Finally, in the contingent liabilities note, find guarantees given on behalf of subsidiaries, joint ventures, associates or related parties. Write that number down beside your net debt, separately.
What you should see. One of 3 pictures.
Comfortable: 1-year maturities are well below cash plus operating cash flow, and guarantees are small. Refinancing is optional. This is most large, stable companies and you can stop here.
Dependent: 1-year maturities exceed cash and are a large multiple of annual operating cash flow. The company is fine as long as lenders keep lending. That is usually true and occasionally not, and it is the condition you must know you are holding.
Larger than it looked: guarantees given are comparable to reported net debt. Your leverage assessment was based on half the exposure.
Do this once a year on every holding and you will never again be surprised by a company that "suddenly" had a debt problem.
Three real cases
1. Dewan Housing Finance, January 2019 to December 2019 (India) — borrowed short, lent long DHFL was a large housing finance company. Its business was funded substantially by short-term borrowing, including commercial paper and bank facilities, while its assets were housing loans lasting many years. That is an asset-liability mismatch, and it is visible in the maturity table of any lender's accounts. Allegations about the company's lending were published on 29 January 2019, mutual funds became unwilling to renew its short-term paper, and it defaulted on payment obligations from June 2019. It was subsequently admitted to insolvency proceedings. The reported debt-to-equity ratio was normal for a housing finance company throughout. The maturity mismatch was the information, and it was published.
2. Lehman Brothers and Repo 105, disclosed 11 March 2010 (United States) — leverage that left the balance sheet on the last day of the quarter Lehman Brothers filed for bankruptcy on 15 September 2008. The court-appointed examiner's report, published on 11 March 2010, described transactions internally called Repo 105, in which the firm transferred assets in exchange for cash shortly before a reporting date and treated the transfer as a sale rather than as borrowing, then reversed the transaction days later. The effect was to reduce reported leverage at the reporting date. Nothing about the firm's actual funding changed. This is the strongest available argument for the point made above: a balance sheet is a photograph of 1 day, and the day is known in advance by the people preparing it.
3. Suzlon Energy, October 2012 (India) — a single dated payment Suzlon was a large Indian wind turbine manufacturer. In October 2012 it failed to repay foreign currency convertible bonds of approximately $209 million on their due date, after bondholders declined a request to extend the deadline. It was among the largest convertible bond defaults by an Indian company at that time. The company had substantial operations, revenue and assets. What it did not have was cash on 1 particular date against an obligation whose date had been known for 5 years. The maturity was disclosed in every annual report from the year the bonds were issued.
The question that resolves it
A novice looks at debt and asks: is the debt-to-equity ratio too high?
An expert looks at the same company and asks: what is due in the next 12 months, who is owed it, and what will pay it?
The first question compares a number with a number somebody invented. The second has 3 answers printed in the annual report, and together they are the whole of solvency analysis.
What would make this wrong
If leverage ratios predicted failure, highly leveraged companies would fail regularly. Most do not. They refinance, year after year, for decades.
Honest limits.
Leverage is not risk on its own. Risk is leverage multiplied by the variability of cash flow. A tollroad with contracted revenue can carry debt that would destroy a steel producer.
Refinancing usually works. Predicting failure from a maturity ladder produces many false alarms. What the ladder actually gives you is the dates on which the question will be answered, which is useful even when the answer is yes.
Year-end figures can be unrepresentative in both directions. Quarterly filings and the CARO answer on quarterly returns filed with banks are the corrections.
Composite scores are weak. The Altman Z-score and similar formulas combine several ratios into 1 number. They were built on old samples of manufacturing companies and travel poorly across industries and countries. Use them as a prompt, never as a conclusion.
In India
The liquidity risk table under Ind AS 107 gives contractual maturities of financial liabilities in bands. It is the single most useful page for this analysis and it is in every large company's report.
CARO answers questions no US filing answers. The auditor must state whether the company has defaulted in repayment of loans or borrowings, and give details including the lender, the amount and the period of default. It must also state whether funds raised on a short-term basis were used for long-term purposes, which is the asset-liability mismatch question asked directly. And it must state whether quarterly returns filed with banks agree with the books of account, which addresses a common form of working capital misreporting.
Credit rating reports are free and detailed. Indian rating agencies publish rationales for every rated instrument, including the maturity profile, the liquidity position and the covenants. A rating action is a public event with a published explanation, and rating downgrades have frequently preceded price falls.
Commercial paper dependence is a specific Indian warning sign for finance companies, because the buyers are mutual funds whose own investors can redeem at short notice.
Promoter pledge data is published quarterly in the shareholding pattern and under the takeover regulations. Rising pledged percentage while the share price falls is one of the highest-signal combinations available in the Indian market.
Both standalone and consolidated debt should be checked. Group debt commonly sits in subsidiaries, and the parent's own balance sheet can look clean while the group is leveraged.
In the United States
The debt note carries a maturity schedule by year for the next 5 years and thereafter, and it is usually more granular than the Indian banded table.
Covenant terms are often described in more detail, and material credit agreements are frequently filed as exhibits to the 10-K, which means you can read the actual contract.
Fixed-rate long-dated bonds are the norm. That means a US company's interest cost responds slowly to rate changes, and the risk concentrates at maturity dates. Read which years carry large maturities and what rate that debt currently pays. A bond issued at 3% maturing into a 6% market is a future profit reduction you can see years ahead.
Credit ratings are published by the major agencies and rating actions are often disclosed. Bond prices and credit spreads are also observable, and a bond trading well below its face value is the credit market's opinion on solvency, which is frequently earlier and better informed than the equity market's.
Pension obligations are a real claim at older industrial companies. An underfunded plan is a long-dated liability, and the funded status is disclosed.
Off-balance-sheet arrangements have their own required discussion in management's discussion and analysis, added after the special purpose entity failures of 2001.
Where they differ, and what that tells you
India gives you a direct answer about defaults. The United States gives you the contract.
The CARO clause requiring the auditor to state whether the company defaulted on loan repayments, and to name the lender and the amount, has no American equivalent. In the United States you infer the same thing from the debt note, the covenant discussion and any 8-K disclosure. If you hold Indian shares, that single CARO answer is worth more than any leverage ratio you can calculate.
The United States gives you the credit market's opinion, which India largely does not. US corporate bonds trade in a liquid market, so you can look at where a company's bonds are priced and see what professional credit investors think. India's corporate bond market is much smaller and less liquid, so equity investors rely on rating agency reports instead. The Indian rating rationale is more detailed than a US rating action announcement, which partly compensates.
The dominant failure shape differs, and so should your first check. In the United States, the classic failure is a company with large fixed-rate bond maturities that cannot refinance when credit markets close. Check the maturity years and the market's view of the credit. In India, the classic failure is a group where the listed company looks sound while debt and guarantees sit in subsidiaries and related entities, and where promoter shares are pledged. Check the consolidated position, the guarantees, the CARO default answer and the pledge percentage.
One point applies equally. Both markets have a known reporting date, and both have companies that manage the balance sheet towards it. In India that date is 31 March for almost everybody, which makes the effect market-wide and predictable. Quarterly data is the antidote in both places.
Carry this
- Build net debt yourself, including leases and acceptances. Note guarantees separately.
- The maturity ladder answers the question the ratios cannot: when is the money due.
- For lenders, use capital adequacy and asset quality. Debt to equity means nothing there.