What is an ideal Debt to Equity ratio?

Investors generally consider debt as a burden, whether it is on themselves or on a company they plan to invest in. While analysing a firm, investors must check whether the company has any debt or not. High debt levels discourage investors from investing in such companies as most of the company's profits might get eroded by interest payments leaving peanuts for the equity holders.

One can gauge the debt level of a company with the Debt/Equity ratio (D/E), which also indicates the company’s aggressiveness in funding its growth with debt. If a company is banking more on external funding (i.e. debt) for its expansion purpose, then it raises concern as higher debt level will lead to additional cost of interest which in turn may result in volatile earnings. One can calculate Debt/Equity ratio by as follows:

Ideally, D/E should be below one, this gives confidence that company can even survive in a downturn business cycle as the company is having lower debt on its books. However, there are many capital-intensive sectors (for example, infrastructure) in which companies are required to borrow to grow in their respective businesses. Investors can even look for an investment opportunity in these spaces, if the company is able to earn enough to service its debt and pay residual to equity shareholders.

Investors can gauge the company's ability to service debt by checking out the interest coverage ratio which is calculated as follows

Ideally, interest coverage ratio should be greater than one, which means that the company is able to generate enough earning to service its interest cost.

Using these two ratios one can spot companies which have manageable debt and higher interest coverage ratio, but simultaneously one should also look into other factors which affect the companies business activities.