KARACHI: Debt is not good or bad in itself. A company that borrows cheaply to build a plant that earns far more than the interest bill has used debt well; a company that borrows to plug holes in a shrinking business is borrowing time, not building value. The problem for investors is that both companies can look identical in a rising market. Debt ratios are how you tell them apart — a small set of calculations, taken straight from the balance sheet and income statement, that show how much a company owes, how easily it services what it owes, and how much room it has when profits dip. This guide works through each ratio, what it measures, how to calculate it from a PSX-listed company's financial statements, and the danger signs that seasoned investors watch for.

Why debt deserves its own set of ratios

Start with what debt actually is. When a company borrows, it signs a contract: interest must be paid on fixed dates, at a fixed or floating rate, and the principal must eventually be repaid or refinanced. Unlike dividends to shareholders, which a board can cut or skip in a bad year, interest is not optional. Miss it and creditors can force the issue — through the courts, through asset claims, or simply by refusing to refinance, which in practice can be just as fatal.

That fixedness is exactly why debt magnifies outcomes. Imagine two identical businesses, each with Rs 1,000 million of assets earning Rs 150 million a year before interest and tax — an illustrative example. Company A has no debt: its shareholders earn the full Rs 150 million (before tax) on their Rs 1,000 million, a 15 percent return. Company B funded half its assets with Rs 500 million of borrowing at, say, an illustrative 10 percent interest rate. It pays Rs 50 million of interest and keeps Rs 100 million — but its shareholders only put up Rs 500 million, so their return is 20 percent. Debt made B's owners richer. Now run a bad year: profits before interest fall to Rs 40 million. Company A still earns 4 percent. Company B pays Rs 50 million of interest on Rs 40 million of operating profit — it is losing money, burning cash, and its shareholders face a wipe-out if the slump lasts. Same business, same assets, radically different risk. That is leverage, and the ratios below are its measuring instruments.

Pakistan adds a local twist. Interest rates here move a lot more than in developed markets: the State Bank's policy rate has swung through very wide ranges over the past two decades, and most corporate borrowing in Pakistan is floating-rate, priced off benchmarks such as KIBOR. A debt load that looks comfortable when money is cheap can become crushing when rates double — and the company's interest bill rises automatically, without it borrowing a single extra rupee. This is why debt ratios matter more, not less, on the PSX, and why you should always ask not just "how much debt?" but "what happens to this company if rates stay high for two years?"

Gearing: the debt-to-equity ratio

The most quoted debt ratio is gearing, usually expressed as debt divided by equity. Equity is the shareholders' stake — share capital plus accumulated retained profits, the bottom section of the balance sheet. Debt, depending on the definition used, means either total borrowings (short-term plus long-term loans) or total liabilities. Because definitions vary, always check which one a data source or annual report is using, and be consistent when comparing companies.

A worked example, with round illustrative figures. Suppose a listed manufacturer reports total equity of Rs 800 million and total borrowings of Rs 1,200 million. Its debt-to-equity ratio is 1,200 ÷ 800 = 1.5 times — for every rupee the owners have in the business, lenders have Rs 1.50. Another company with the same equity but Rs 240 million of borrowings has a ratio of 0.3 times. Neither number is automatically "good" or "bad": a regulated utility with contracted, predictable cash flows can carry high gearing safely for decades, while a cyclical textile exporter whose profits swing with cotton prices and the exchange rate may be fragile at half that level. Context — the stability of the earnings stream — is what turns a ratio into a judgement.

A close cousin is the debt-to-assets ratio: total debt (or total liabilities) divided by total assets. It answers a blunter question — what fraction of everything the company owns was funded by lenders rather than owners? If liabilities are Rs 1,200 million against assets of Rs 2,000 million, the answer is 60 percent. Lenders like this ratio because assets are what they would claim against in a failure; investors like it because it is hard to flatter. Watch the equity side too: a company that keeps losing money shrinks its equity every year, so its gearing rises even if it never borrows more. Rising gearing driven by eroding equity is one of the quietest danger signs in Pakistani annual reports.

Interest cover: can profits pay the bill?

Gearing measures the stock of debt; interest cover (also called the times-interest-earned ratio) measures the flow — whether current profits can service it. The formula is simple: operating profit (earnings before interest and tax, or EBIT) divided by the finance cost for the same period. Both figures sit in the income statement, which makes this the easiest ratio to compute from any PSX results announcement.

Take an illustrative company with EBIT of Rs 300 million and finance costs of Rs 100 million. Interest cover is 3.0 times: profits could fall by two-thirds before the company fails to cover interest from earnings. Contrast a company with EBIT of Rs 120 million and finance costs of Rs 100 million — cover of 1.2 times. A 20 percent dip in profits, an ordinary event in a cyclical industry, puts it underwater: it must then pay interest out of cash reserves, asset sales or fresh borrowing, each of which weakens it further. As a rough orientation — not a rule — cover below about 1.5 times deserves close scrutiny, and cover below 1.0 means current earnings do not pay the interest bill at all.

Two refinements separate careful readers from casual ones. First, use a full year, and ideally look at several years: a single strong quarter can flatter cover for a seasonal business. Second, remember that interest is paid in cash but EBIT is an accounting number that includes non-cash items and profits that may be tied up in receivables. A stricter version replaces EBIT with operating cash flow from the cash flow statement. A company can report healthy profits and still scramble for cash to pay the bank — our guide to reading a cash flow statement shows how that gap opens up. Interest cover calculated on cash is the version that keeps treasurers awake.

Net debt, and the debt service coverage ratio

Sophisticated analysts rarely stop at gross debt. Net debt subtracts cash and bank balances from total borrowings: a company with Rs 1,000 million of loans and Rs 700 million sitting in bank deposits has net debt of Rs 300 million, a very different risk profile from the headline figure suggests. Comparing net debt to earnings gives the widely used net debt-to-EBITDA ratio. EBITDA — earnings before interest, tax, depreciation and amortisation — approximates the cash a business generates from operations before financing decisions. If net debt is Rs 900 million and EBITDA is Rs 300 million, the ratio is 3.0 times: roughly three years of operating cash earnings to repay all net debt, if every rupee were diverted to lenders (which it cannot be — taxes, maintenance spending and working capital also claim their share). Treat the ratio as a scale, not a countdown.

Project-financed businesses, especially in Pakistan's power sector, are judged by a stricter measure: the debt service coverage ratio (DSCR), which divides cash available for debt service by the total actually due in the period — interest plus scheduled principal repayments. Principal is the part beginners forget: interest cover can look adequate while a large loan instalment looms. Whenever you read an annual report, the borrowings note breaks debt into amounts due within one year and amounts due later. A heavy concentration in the "within one year" bucket, against modest cash generation, is a refinancing risk — the company must persuade lenders to roll the debt over, in whatever interest-rate environment prevails at the time.

Short-term versus long-term: the maturity question

Not all debt is equally dangerous. Long-term debt matched against long-lived assets — a fifteen-year loan funding a plant with a twenty-year life — is the textbook structure. The danger pattern is the opposite: short-term borrowing funding long-term assets, or worse, short-term borrowing funding losses. Short-term debt must be repaid or renewed within months. Pakistani businesses have historically relied heavily on short-term running finance and working-capital lines, which are cheap and flexible in good times and can be squeezed precisely when the economy tightens and the company needs them most.

The balance sheet tells you the mix at a glance: borrowings are split between current liabilities (due within a year) and non-current liabilities. A company whose debt is overwhelmingly current, with thin cash balances, is living on its bankers' goodwill. Cross-check with the liquidity ratios in our guide to working capital and the cash conversion cycle — the current ratio and quick ratio pick up exactly this short-term pressure from a different angle.

Also read the borrowings note for what kind of debt it is. Pakistani balance sheets commonly include: conventional bank loans and running finance; Islamic financing structures (diminishing musharakah, ijara) which function economically like debt whatever the legal form; long-term project debt, often in foreign currency for power and energy companies; debentures and sukuks issued to the public; and — easy to overlook — lease liabilities, which accounting standards now place on the balance sheet and which are debt in all but name. Foreign-currency debt deserves a special flag: if a company earns rupees but owes dollars, a depreciation of the rupee inflates the debt burden automatically. Companies with dollar-linked revenues, such as exporters and many energy firms, have a natural hedge; a purely domestic business with dollar debt does not.

How debt ratios differ by sector

Ratios only mean something against the right comparison group. Banks are the extreme case: taking deposits and lending them on is the business, so a bank's balance sheet is mostly liabilities by design, and ordinary gearing ratios are meaningless for it — bank analysis uses capital adequacy and other regulatory measures instead. Power generation companies on the PSX were typically built with project finance — heavy debt at construction, repaid steadily from contracted capacity payments — so high initial gearing is structural, and the question is whether the contract cash flows cover debt service, which is why the DSCR dominates there. Cement, steel and other capital-intensive manufacturers sit in the middle: meaningful plant debt, but earnings that swing with construction demand and energy costs, so moderate gearing with strong cover is the comfortable zone. Consumer and pharmaceutical companies often run with little debt at all, funding growth from their own cash generation; for them, a sudden jump in borrowings is itself a question to ask — what changed?

The practical method is simple: compare a company with (a) its own history over five years, and (b) two or three direct competitors in the same sector today. A ratio drifting steadily in the wrong direction across several annual reports is information; a single year's figure is a snapshot. And remember how these ratios connect to returns: leverage inflates return on equity in good years, which is why our guide to ROE and ROA pairs the two measures — a spectacular ROE built on thin equity and heavy debt is a different achievement from the same ROE earned unlevered.

The danger signs, gathered in one place

Pulling the threads together, experienced readers of Pakistani financial statements slow down when they see:

  • Interest cover trending down toward 1.5 times or below, especially if profits are flat but finance costs keep climbing — the signature of rising rates on floating debt.
  • Gearing rising because equity is shrinking — accumulated losses eating the owners' stake — rather than because the company borrowed for expansion.
  • A maturity wall: a large share of debt due within twelve months, modest cash on hand, and no announced refinancing.
  • Short-term debt funding long-term assets, visible when current borrowings grow alongside fixed-asset additions.
  • Debt growing faster than sales or operating profit for several consecutive years — borrowing to stand still.
  • Foreign-currency borrowing without foreign-currency earnings, leaving the company exposed to rupee depreciation.
  • Frequent rescheduling, restructuring or "reprofiling" language in the notes, or auditors raising going-concern questions.
  • Dividends maintained while debt climbs — shareholders being paid with lenders' money rarely ends well.

None of these, alone, proves a company is in trouble; companies refinance, rates fall, and profits recover. But two or three together describe a business whose margin for error has thinned — and in investing, most permanent losses come not from businesses that were obviously doomed but from leveraged ones that met one bad year too many.

Putting it into practice

Build a small habit. For any company you are studying, open the latest annual report, find the balance sheet and the finance-cost line in the income statement, and compute three numbers: debt-to-equity, interest cover, and net debt. It takes ten minutes. Then open the previous year's report and do it again, so you have a direction, not just a level. Write the three numbers down with the date; when the next results arrive, update them. Over a few reporting cycles you will develop the most valuable instinct in credit analysis — noticing change early, while it is still a trend and not yet a crisis.

One last proportion check. Debt ratios describe a company's finances, not your own risk: how much of your money sits in any single leveraged company is a separate decision, covered in our guide to position sizing and risk per trade. This article is educational content, not financial advice — ratios inform your own research; they do not make the decision for you.

Key takeaway: gearing tells you how much a company owes relative to its owners' stake, interest cover tells you whether profits can pay for it, and the trend across years — plus what falls due soon — tells you whether the debt is fuel or a fuse.