68 Strategic Financial Management

6. Guaranteed redemption of preference shares on a targeted date puts pressure on a corporation's

liquidity. Therefore, the computation of the D/E ratio can be done with two different views or
purposes as follows:
View 1: Debt/equity based on the 'liquidity factor'
Borrowed fund + Preference share capital
Equity share capital + Reserves
As mentioned earlier, preference share capital influences long-term liquidity of a corporation;
therefore it can be clubbed with the borrowed fund.

View 2: Debt/equity based on the 'servicing factor'

Borrowed fund
Equity share capital + Reserves + Preference share capital
Servicing of the preference share capital is not compulsory when a corporation incurs loss. Cost
of servicing this capital is dividend, which is paid out of PAT. Therefore, it is obvious that dividend
does not give any tax shield to the corporation. Dividend is tax free in the hands of investor (whereas
interest is taxable).

Monitoring the Debt/Equity Mix and Its Performance

We concluded that a high D/E ratio offers multiple advantages to the corporation and its shareholders.
The other relevant conclusion was that this corporation must possess excellent products, processes
and people. But a high D/E ratio means high amount of borrowed fund and high amount of its
servicing cost. Hence, an alert and continuous monitoring of a high D/E ratio is very important to
avoid any problem of servicing the borrowed fund.
Such monitoring can be done with a very useful support ratio called 'debt service coverage ratio'
(DSCR). This ratio measures and shows the adequacy of a corporation's cash profit to pay annual
cost of interest and repayment of annual loan instalment. Normally a pragmatic average DSCR is
expected to be 2 : 1, i.e., the cash profit should be double of the total amount of annual cost of interest
plus annual loan instalment.

Cash PAT before interest PAT + Depreciation + Interest

DSCR – –
Interest + Loan instalment Interest + Loan instalment
Let us now answer a question: Why should DSCR be 2 : 1? On an average, an operating ROI (as
discussed in our initial discussion) should take care of three things—real (or opportunity) cost of
capital, profit withdrawal for the owner's personal consumption and reinvestment of profit to build up
reasonable amount of reserves for tomorrow's growth. This can be well explained with the following
example:
Any fund (whether own or borrowed) has a cost (real or opportunity), irrespective of the nature
of its source. Hence, servicing of a fund is a must at a reasonable rate of real or notional interest.
Normally, the rate of interest cost is equal to the existing 'prime lending rate' (PLR) or an average
rate of cost of capital prevailing in the industry or an average rate of cost of capital in the group of
companies under the same control or same ownership. The owner or entrepreneur must get a reward
for his entrepreneurship or ownership. In other words, such reward is his disposable or consumable
income. The corporation must build up a reserve for tomorrow's growth, diversification, correction,
renovation and any unexpected calamity.
As a thumb rule, 50 per cent of the cash profit can be used for servicing the borrowed fund, and
25 per cent can be reinvested in the corporation to create a reserve. If a DSCR takes care of only the
first and second requirements, it may be called a 'break even DSCR.' In a developing country like