Investing in corporate bonds? Check these ratios to assess whether the company can repay you

Investing in a corporate bond can be rewarding, provided you do it after thorough consideration. Since companies issue these bonds to raise debt, investors need to double-check the company’s financial strength or repayment capacity. One must be sure that the company is capable of repaying the principal and interest due to him/her. But how, you may ask? This article explains.

You can assess the health of a company by examining its business model and financial performance using certain ratios. You may even try to meet or observe the company’s management to better understand their ability to meet repayment obligations.

You can get a big clue about a company’s repayment capacity by analysing its financial statements. If you are not familiar with finance, you may find it difficult to understand a company’s financial statements. However, understanding a few simple ratios can help.

Debt-to-Equity ratio

The debt-to-equity ratio can be calculated by dividing a company’s total debt by its total equity. For example, suppose a company's total debt is ₹250 crore and its total equity is ₹1000 crore. In this case, the debt-to-equity ratio is 1:4.

This ratio indicates how much the company has borrowed relative to its own funds. In other words, this ratio tells you how leveraged the company is. A high debt-to-equity ratio suggests that the company has been financing its growth by raising a lot of debt. Before investing in such a company’s bonds, one should check whether the company’s financials are sound enough to handle such a high level of debt.

Interest coverage ratio

The interest coverage ratio can be calculated by dividing a company’s EBITDA by its net interest expenses. With this ratio, one gets the idea about whether the company is generating enough income to service its interest payments. For example, suppose a company’s EBITDA is ₹500 crore, and its net interest expenses are ₹50 crore. In this case, the company's interest coverage ratio is 10.

Ideally, a good company’s earnings should be significantly higher than its interest payments. A high interest coverage ratio means a company is in a good position to make interest payments.

Some other ratios

Apart from the above ratios, corporate bond investors should assess a company’s cash flow, market share changes, and increase in revenue assets over the past few years.

If a company’s net profit and market share have increased over the last few years, it can be said to be performing well.

Apart from ratios, bond investors may also look at the maturity pattern of a company’s existing loans. One can check whether the company has a significant amount of debt maturing soon and whether it can be rolled over. Further, you can check whether the company has been a defaulter in the past or has frequently rolled over its debt.