How much debt is too much?
When a company borrows money, it can use that capital to grow faster. But debt comes with a cost — interest payments that must be made regardless of whether business is good or bad.
Debt to Equity ratio (D/E)
Total debt divided by shareholders' equity. A D/E of 1 means the company has borrowed as much as it owns. A D/E of 0.5 means it has borrowed half of what it owns.
Below 0.5 — Low debt, generally safe. 0.5 to 1 — Moderate, manageable for most businesses. Above 1 — High, watch carefully. Above 2 — Very high, one bad year could be dangerous.
These rules change by sector. A bank with D/E of 10 is completely normal — debt is their raw material. A manufacturing company with D/E of 3 might be in trouble. Always compare within the same sector.
Interest Coverage ratio
Operating profit divided by interest expense. This tells you how comfortably the company can pay its interest bill.
Above 5 — Very comfortable, plenty of buffer. 3 to 5 — Adequate, some cushion. 1 to 3 — Tight, little room for error. Below 1 — Danger: the company is not earning enough to cover interest.
Not all debt is equal
Good debt funds assets that generate returns higher than the interest cost. A company borrowing at 10% to earn 20% ROCE is using debt intelligently.
Bad debt funds losses, dividends the company cannot afford, or assets that generate no return. This kind of debt compounds problems.
Ask: what is this debt being used for? Expansion and growth are usually fine. Covering operating losses is a serious warning sign.
Promoter pledge — a specific warning
In India, watch for promoter pledge — when the promoters of a company pledge their own shares as collateral to borrow money personally.
If the stock price falls sharply, lenders can sell those pledged shares. That selling drives the price down further, which triggers more selling. This cycle can destroy a stock very quickly.
Always check the shareholding pattern for pledge percentage. Anything above 20% of promoter holding being pledged deserves serious attention.
The Altman Z-Score shortcut
Rather than calculating each ratio manually, the Altman Z-Score combines five financial ratios into a single number that predicts financial distress. Above 3 is the safe zone. 1.8 to 3 is the grey zone. Below 1.8 is the danger zone.
Understock shows the Altman Z-Score for every company. Use it as a quick health check before going deeper into the numbers.
See it in practice
Search for a stock on Understock