Analyzing Debt Funds in Financial Statements

Every business needs money to run, and not all of it comes from the owners’ pockets. A large chunk usually comes from lenders, banks, and bondholders who expect their money back with interest. In accounting language, this borrowed money is called debt funds or external equities, and it sits right there on the balance sheet, telling a story about how a company is funded and how risky that funding really is. If you want to actually understand a company’s financial statements rather than just skim them, learning to read its debt funds is non-negotiable.

What exactly are debt funds? 🔗

Debt funds represent all the money a business has borrowed from outside parties rather than raised from its own shareholders. This is why they’re also called external equities, as opposed to internal equities, which is the owners’ capital and retained profits. Debt funds include everything from a short-term overdraft used to pay suppliers to a 15-year term loan used to build a factory.

The common thread is simple: whoever lent the money has a legal claim on the business, and that claim has to be honoured before shareholders get anything, whether the company is doing well or badly. This is what separates debt from equity. Equity holders share in the upside and downside of the business; debt holders just want their principal and interest paid on schedule, regardless of how profitable the year was.

Where debt funds sit on the balance sheet 🔗

Under the format prescribed by Schedule III of the Companies Act, every liability on an Indian company’s balance sheet has to be classified as either current or non-current, based mainly on whether it falls due within twelve months of the reporting date, or within the company’s normal operating cycle if that’s longer. This single rule decides where a debt fund lands, and it’s the first thing to check when you’re analysing a set of accounts.

Long-term debt funds 🔗

Long-term, or non-current, debt funds are borrowings that won’t be repaid within the next year. This bucket typically includes term loans from banks and financial institutions, debentures, bonds, and long-term deposits. Debentures in particular are worth understanding well, since they’re a favourite exam topic. A debenture is essentially a certificate acknowledging a company’s debt, issued to raise long-term funds at a fixed rate of interest, and depending on the terms, it can be secured against company assets or left unsecured, resting purely on the issuer’s creditworthiness.

Short-term debt funds 🔗

Short-term, or current, debt funds cover obligations due within a year. This includes short-term borrowings such as cash credit and working capital loans, trade payables, current maturities of long-term debt (the portion of a term loan due in the next twelve months), and short-term provisions. A useful trick students often miss: if a debenture is nearing its final year before redemption, it doesn’t stay in long-term borrowings. It gets reclassified as a current liability, since it’s now due for repayment within the year.

Reading debt funds through leverage 🔗

Once you know where debt funds are recorded, the real analytical work begins. The most common tool for this is the debt-to-equity ratio, which compares total borrowed funds to shareholders’ equity. For an Indian manufacturing company with current liabilities of ₹250 crore and non-current liabilities of ₹450 crore against shareholders’ equity of ₹500 crore, the debt-to-equity ratio works out to 1.4, meaning the company has ₹1.4 of debt for every rupee of equity.

Interpreting the number 🔗

There’s no single “correct” ratio, but rough benchmarks help. A ratio below 1 generally suggests a company leans more on equity, which usually means lower financial risk, while a ratio between roughly 1 and 1.5 is often seen as a reasonably healthy balance, showing debt is being used for growth without overexposing the company. Ratios well above that start to raise questions about how comfortably the company can service its obligations if profits dip.

Why leverage matters beyond the number 🔗

Leverage ratios exist because lenders, investors, and analysts need to know whether a company can manage its repayment obligations without stress, and they offer a window into how a company balances risk and return through its capital structure. Debt-to-equity is the most common leverage ratio, but analysts also look at debt-to-assets and interest coverage to build a fuller picture. This is context Indian students should keep in mind, since the debt component for most domestic companies includes term loans, non-convertible debentures, and working capital borrowings, while equity comprises promoter holdings and public shareholding.

Debt and risk: liquidity versus solvency 🔗

Debt funds create two distinct kinds of risk, and it’s worth separating them clearly.

Short-term liquidity risk 🔗

High current liabilities relative to current assets and cash flow can trap a company in a liquidity crunch. It might be profitable on paper but still struggle to pay a supplier or meet a loan instalment next month. The current ratio, current assets divided by current liabilities, is the standard check here. A ratio comfortably above 1 suggests the company has enough short-term resources to cover its short-term debt.

Long-term solvency risk 🔗

Long-term debt funds bring a different kind of pressure: ongoing interest payments and an eventual repayment obligation, sometimes years away. Here, the interest coverage ratio, operating profit divided by interest expense, tells you how comfortably a company’s earnings cover its interest bill. A thin coverage ratio is often an early warning sign, well before a company actually defaults.

The cost of borrowing and why it matters for planning 🔗

Debt isn’t free, and its cost shows up in more than one place. Interest paid on loans and debentures is recorded as an expense in the profit and loss statement, reducing net profit, while the principal itself sits as a liability on the balance sheet. Since interest is usually tax-deductible, debt can work out cheaper than it first appears once the tax saving is factored in.

But the more important idea for financial planning is leverage. Borrowing only helps shareholders when the return the company earns on its assets exceeds the cost of that borrowed money. This relationship is neatly captured in the formula ROE equals ROA plus the spread between ROA and the cost of debt, multiplied by the debt-to-equity ratio. If a company earns more on its assets than it pays in interest, leverage magnifies shareholder returns. If earnings fall below the cost of borrowing, that same leverage magnifies the losses instead. This is exactly why heavily leveraged companies look great in good years and get punished hard in bad ones.

Debt funds in the Indian corporate landscape 🔗

Debt levels across Indian companies move with the broader economic cycle, and tracking them offers real insight into corporate health. During periods of slowing demand and weaker profitability, for instance, India’s private sector debt-equity ratio has risen even as borrowings grew faster than shareholders’ net worth, a pattern analysts read as a sign of balance sheet stress rather than confident expansion. Public sector undertakings have shown similar patterns in specific periods, underlining that leverage trends aren’t just theoretical numbers in a textbook; they move markets, credit ratings, and lending decisions in the real economy.

For a student analysing any Indian company’s annual report, the checklist stays fairly consistent: identify the current and non-current debt funds from the balance sheet notes, calculate the debt-to-equity and interest coverage ratios, and compare them against industry peers and the company’s own historical trend rather than against some fixed universal benchmark.

What do you think? If you were analysing two companies with an identical debt-to-equity ratio, but one had all its debt maturing next year while the other had it spread over ten years, would you treat their risk as the same? And when does borrowing more actually make a company stronger rather than riskier?

References

1. https://fi.money/guides/us-stocks/how-to-calculate-the-debt-to-equity-ratio
2. https://www.truedata.in/blog/solvency-leverage-ratios-debt-to-equity
3. https://www.bajajfinserv.in/investments/leverage-ratio
4. https://www.winvesta.in/blog/investors/debt-to-equity-ratio-assessing-financial-risk-in-stocks
5. https://www.business-standard.com/article/companies/india-inc-balance-sheets-weaken-in-fy19-net-debt-equity-ratio-inches-up-119071400590_1.html