Corporates increase leverage as debt accumulated at faster pace

• Debt to equity ratio as at end 2020 was 42%, up from 37% end 2019

Sri Lankan corporates have accumulated debt at a faster pace making the most of the record low borrowing cost, upending the funding structure and their balance sheets for many years to come as the economy is slowly adjusting to low interest rates. 

The debt-to-equity ratio of the corporate Sri Lanka, a key gauge of the corporate sector leverage, continued its climb through 2020, as businesses received a better deal from their debt holders than their stock holders to fund their working capital and expansion projects amid the pandemic driving interest costs and yields of debt securities to a record low.

The debt-to-equity ratio, which was at 33 percent at the end of the first half of 2018, rose to 37 percent a year later and further up to 42 percent at the end of 2020, reflecting the pace at which low interest costs are drawing companies to borrow to reduce their overall cost of capital, Central Bank data showed.  

The ratio is measured taking total debt as a share of total equity of the corporate sector. 

Debt is generally considered cheaper than equity up to an optimal level as the former is generally secured by assets while the latter assumes the business risk including the risk of losing everything in the case of liquidation. Further, debt becomes more attractive than equity as interest is tax deductible while dividend paid for equity is not.

While rising debt itself doesn’t reflect financial risk to a company, what matters most is the ability to service such debt, which is measured through what is known in corporate finance terminology as the, ‘interest coverage ratio’. 

While the ratio has over time declined from 5.5 times in 2018 to 3.3 times in 2019 and further towards 2.6 times in 2020 by the first half of the year, projecting weakness based on the available data, the stronger earnings spell during the second half of the 2020 and the expected record earnings in the first quarter in 2021 were expected to have strengthened the companies’ ability to service their borrowings, comfortably than earlier. 

Sri Lanka’s listed companies recorded their highest quarterly earnings season in December 2020 after recording a two-year high earnings spell in September 2020. Analysts broadly expect companies to either repeat the December earnings spell or to do even better in the March 2021 quarter as corporates received an additional tailwind to their top lines from the resurgent consumer spending, improving their interest cover. 

“…it is apparent that the debt moratorium, concessionary interest rates and accommodative monetary policy measures would provide considerable ease to the financial statements of corporates as well,” the Central Bank said referring to the relief measures which significantly reshaped the funding profiles and the balance sheets of the country’s corporate sector, particularly since 2020.

Lower borrowing costs leave higher earnings for companies, which in turn lead to higher stock prices resulting in higher market values.