What is an ideal debt-equity ratio of a company?

Debt-to-Equity ratio compares the Total Liabilities to the Total Equity of the company. It paints a useful picture of the company's liability position and is frequently used. Debt-to-Equity Ratio = Total Liabilities / Shareholder's Equity Both the Total Liabilities and Shareholder's Equity are found on the Balance Sheet. When this number is less than1, it indicates that the company's creditors have less money in the company than its equity holders. That, typically, would be an ideal threshold to be below. It's common for large, well-established companies to have Debt-to-Equity ratios exceeding1. For instance, GE carries a Debt-to-Equity ratio of around4.4 (440%), and IBM around (1.3)130%.

The ideal debt-to-equity ratio depends on various factors including the industry in which company is operating. Moreover, the following read gives a good idea to understand the concept:

 

Debt-to-equity ratio

A company's debt to equity ratio shows you what proportion of debt or equity a company is using to finance its assets. The debt to equity ratio is calculated by dividing its total debt by its total shareholder equity:

Debt/equity ratio = Total debt/shareholder equity

A high debt to equity ratio shows that the company has a relatively heavy debt load.

This is usually a bad sign for shares investors because the cost of servicing high debt levels can pressure a company's earnings and make them more volatile. It can also do the same to its share price.

 

Debt is not necessarily a bad sign

Heavy debt is not always a danger sign though, especially for capital-intensive industries like car manufacturing, which typically have a debt to equity ratio higher than2 and are still considered healthy.

In contrast, software companies, which do not need lots of expensive machinery to produce their goods, tend to have a debt to equity ratio as low as0.5.

Also, if money that has been borrowed is invested prudently it can boost a company's future earnings.

 

The cost of borrowing is a significant factor

What a potential shareholder need to research is how much that debt is costing the company in interest.

If the earnings growth that the borrowed money generates is higher than the cost of borrowing it, a high debt to equity ratio can be a positive for the company's financial health and its share price.

For example, if a company has total debt of £2 million and total assets of £2 million, this gives it a debt to equity ratio of1. If it then takes out a £4 million loan to buy a new production facility, its debt to equity ratio will rise to an unhealthy-looking3.

If however, the new factory generates a6% return on assets and the interest on the loan is4%, the relatively high debt to equity ratio is positive for the company and could boost its share price.

If interest rates on the debt later rise to7%, the company is now paying more for its debt than the6% return on assets the factory is generating. This could in the long term lead to bankruptcy, and wipe out the value of the company's shares.

Shares investors should therefore keep an eye on national interest rates and on a company's credit rating.

 

If interest rates are rising or a company's credit rating falls, it will have to pay more for its debt. This will help you gauge how much of a potential problem a high debt to equity ratio might become.

The ratio at which the required rate of retun on capital is the lowest

it dpends upon industry to industry and on type of organisation also but ideal would be1 :1

Total Equity should be higher than total Debt of a company.

Debt is cheeper source of finance while equity based finance strengthing or improve credit rating so suitable proportion is  50:50

  

If debt/equity ratio is2:1 then definitely it is not a good company. It means that for every rupee that the company has, it has a debt of2 rupees. Not a good scenario. No company have zero debt. It is very rare. Every company will take some loans to expand its business, but if the ratio is more than1 then it means it is shelling out more towards the debt than the equity it has. Instead, a company with low debt/equity ratio (ideally less than1 or0.5) will have less debt to take care of. So, its earnings will be sufficient to service the debt and also some free funds to take care of other business activities like expansion, diversification of business or starting a new venture altogether. If you want to invest in a company, choose one which has consistently kept its debt equity ratio at a minimum and preferably one which shows a decreasing trend year on year.

Debt Equity ratio is normally considered for acquiring finances from the financial institutions. So We need to check the Prudential regulations for the minimum requirements of Debt Equity ratio and Current Ratio. You need to check the Prudential regulations of your country to get the exact value.

There is no ideal number, it all depends on the sensitivity of your earnings, what kind of share holders you have and their perception of debt, the cost of debt, the availability of investable projects that add value to company. Having more debt icreases the default risk but generates higher returns to owners, so its an art and personal judgement. In UAE unfortunately on average people percieve debt as a negative tging and hence tend to reject it on shallow levels. Also since the majority of companies in uae are small to medium enterprises, this means thst they tend to have low access to cheaper financing options and are not soficticated enough to understand corporate cash investments and the wacc.