scorecardresearchAdani-Hindenburg: What is an ideal debt-equity ratio? MintGenie explains

Adani-Hindenburg: What is an ideal debt-equity ratio? MintGenie explains

Updated: 17 Feb 2023, 04:55 PM IST

At a time when large entities such as Adani Group face flak for holding massive debt on their balance sheets, we explain what are the debt ratios.

Too much of debt brings under the scanner not only the company’s profitability but also its solvency in the foreseeable future

Too much of debt brings under the scanner not only the company’s profitability but also its solvency in the foreseeable future

There is an old German saying that says, “He who is quick to borrow is slow to pay.” This is true not only of individuals but also of organisations. Growth is seen as organic and sustainable when it is not heavily financed by debt.

From an individual to a government — borrowings are prevalent and are seen as well-accepted means of funding. However, the problem begins when the loan becomes overwhelmingly large in comparison to the size of the organisation.

One of the key concerns raised by Hindenburg Research in relation to Adani Group in its report released on Jan 24 is the excessive amount of debt that the Gautam Adani-headed company has taken, thus making its future precarious and perilous. 

The report says that the group’s rapid expansion is debt-funded, and five of the seven listed companies have near-term liquidity pressure because of this.

This brings to the question as to exactly how much of the debt is fine, and exactly at point is the red line crossed.

Let us understand this with the help of an illustration. A loan of $100 million is not too much for a company with a market cap of $10 billion, but when a smaller organisation with a market cap of 10 million borrows a loan of $100 million, then it can set the alarm bells ringing.

So, to be able to gauge the future profitability and sustainability of an organisation, it is vital to compare the total debt in relation to the company’s market cap and equity.

And to do a fair assessment – one should compute some financial ratios. These include the following.

Debt to equity ratio

It is a financial leverage ratio that is often used to check the size of a company’s debt-burden. It compares the owner’s equity or capital to total loan or debt, i.e., funds borrowed by the company.

In other words, it computes a company’s total liabilities to its shareholder equity. It is widely seen as an important yardstick of valuation since it shows a company’s dependence on borrowed money and its financial capacity to meet those obligations.

What is an ideal debt-equity ratio?

The ideal debt equity ratio varies from industry to industry, but it is expected that the ratio does not breach the level of 2.

When it hits the level of 2, it shows that the company’s two-third capital financing comes from debt while the remaining one-third from shareholder equity.

According to a Bloomberg report in August 2022, Adani Green Energy's debt-to-equity ratio was 20 times, the second worst in Asia.

At the same time, while looking at a company’s balance sheet — it is vital to compare its debt-equity ratio with that of the industry and those of its rivals.

Debt to earnings ratio

A debt-to-income ratio is a measure that calculates the total amount of debt divided by the total earnings.

Adani Group’s ports unit is now considering to repay $604.6 million of loans to trim debt and improve its debt to earnings ratio after the Hindenburg report went public.

The ratio currently is just over 3 times and would improve to 2.5 after the repayment, says another Bloomberg report.

Debt-servicing ratio

The debt-service coverage ratio (DSCR) calculates a firm’s available cash flow to pay its loan obligations. The ratio indicates whether an organisation has sufficient money to pay its debts.

When the ratio is greater than 1, it shows that the company has barely enough operating income that would cover annual debt obligations. And when the calculation is lower than one, it indicates the company is unable to meet its debt – at least in the immediate future and triggers the spectre of insolvency.

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First Published: 17 Feb 2023, 04:55 PM IST