The stock of Adani Group underwent considerable volatility after New York based Hindenburg Research raised concerns relating to massive debt that the company has taken in the recent past.
The report raised questions over the frantic pace with the ports-to-power conglomerate grew, a large part of which is financed by loans.
The company’s stock has, nevertheless, recouped some of the losses and traded in green on Monday.
Although financing growth and expansion via loan is usual for any company and industry, but the critics assert that the debt should be serviced easily with the cash flow and the income that the company generates.
So, what is the ideal debt ratio, and which are the debt ratios a business enterprise can rely on. There are three key debt ratios: debt asset ratio, debt equity ratio and debt service coverage ratio.
What is an ideal debt ratio?
Lower debt ratios are considered better since too much of debt is harmful to the company and reduces its net profit.
A high debt ratio makes it hard for a company to raise further loans. Some banks and financial institutions have earmarked a threshold of debt ratio above which they don't lend to companies.
But it does not mean debt ratio of zero is good. Since debt is a cheaper form of financing over equity financing, so too little debt restricts the ability of companies to finance its operations.
Key debt ratios
Debt-asset ratio: One of key debt ratios is the debt-asset ratio. It can be calculated by dividing total liabilities with total assets. This shows the number of times debt is higher than assets. A debt-asset ratio of two means the size of debts is double the size of assets.
This works as one of the solvency ratios for investors and they can evaluate the possibility of a firm going bankrupt in the long run based on the debt-to-asset value.
When this ratio is less than 1, it is seen as ideal, while it may vary from industry to industry for which it is being calculated.
Debt-equity ratio: Another important debt ratio is debt-equity ratio. This, effectively, means the number of times debt is higher than equity. For instance, a debt-equity ratio of 1.5 means the debt is one and a half times the size of equity.
The ideal debt equity ratio varies from industry to industry, but it is expected that the ratio does not breach the level of 2.
Debt-service coverage ratio: The debt-service coverage ratio (DSCR) evaluates a firm’s available cash flow to pay its loan obligations. It is calculated by dividing net operating income with debt service.
The ratio shows whether an organisation has enough money to clear its debts. It is calculated by dividing net operating income with debt service.
When this ratio is greater than 1, it shows that the company has barely enough operating income that would cover annual debt obligations.