You may have heard of the concept of “bad” and “good” debts. Bad debts are things like built-up credit card balances that continue to cost you money because of interest, while good debt can help you accomplish your goals, such as taking out a mortgage to buy a house.
And debt isn’t just personal. Companies also use “good” debt, also known as leverage, to help them accomplish business goals and finance operating costs. The ratio used to measure this leverage is called the debt-to-equity ratio (D/E). Knowing it may be helpful in making investment decisions.
What Is the Debt-to-Equity Ratio?
As you start investing, there are a number of measures that may help you to evaluate individual stocks, including the debt-to-equity ratio. At its simplest, the debt-to-equity ratio is a measure of how much debt it takes for a company to run its business.
It compares a company’s equity—how much value is locked up in its shares—to its debts. Another way of looking at it is as a measure of a company’s ability to cover its debts. For example, if a company were to liquidate its assets, would it be able to cover its debt? How much money would be left over for shareholders?
Investors often use the debt-to-equity ratio to determine how much risk a company has taken on, and in return, how risky it may be to invest in that company. After all, if a company goes under and can’t cover its debts, shareholders may be left with nothing.
What Is Leverage?
To understand the debt-to-equity ratio, it’s helpful to understand the concept of leverage. Businesses have two options when it comes to paying for operating costs.
They can either use equity, or they can use debt, aka leverage. This debt can be used to buy equipment, inventory, or other assets.
While it’s potentially risky to use leverage—a company might have to declare bankruptcy if it can’t pay its debt—it can also help a company grow beyond the limitation of its equity.
The term leverage is used because of the hope that the company will be able to use a relatively small amount of debt to boost their growth and earnings.
Wise use of debt can help companies build a good reputation with creditors, which in turn will allow them to borrow more money for potential future growth.
The Debt-to-Equity Ratio Formula
Calculating the debt-to-equity ratio is fairly straightforward. A good first step is to take the company’s total liabilities and divide it by shareholder equity. Here’s what the formula looks like:
D/E = Total Liabilities / Shareholders’ Equity
Here’s a closer look at the two components of the equation:
• Total Liabilities: This component comprises a company’s current and long-term liabilities. Current liabilities are the debts that a company will typically pay off within the year, including accounts payable. Long-term liabilities are debts whose maturity extends longer than a year. Think mortgages on buildings or long-term leases.
• Equity: The equity component is made up of two portions: shareholder equity and retained earnings. Shareholder equity is the money investors have paid in exchange for shares of the company stock. Retained earnings are profits that the company holds onto that aren’t paid out in the form of dividends to shareholders.
To look at a simple example of a debt-to-equity calculation, consider a company with total liabilities worth $100 million dollars and equity worth $85 million. Divide $100 million by $85 million and you’ll see that the company’s debt-to-equity ratio would be about 1.18.
When calculating real-world debt-to-equity ratios, you’ll probably be able to find figures for both total liabilities and shareholder equity on a company’s balance sheet. Publicly traded companies will usually share their balance sheet along with their regular filings with the Securities and Exchange Commission (SEC).
What Is a Good Debt-to-Equity Ratio?
Once you’ve calculated a debt-to-equity ratio, how do you know whether that number is good or bad? As a very general rule of thumb, a good debt-to-equity ratio will equal about 1.0. However, what is considered acceptable will likely vary by industry.
For example, if a company requires a lot of capital to operate, such as a manufacturer, it may need to take on a lot of debt to finance its operations. A company like this may have a debt-to-equity ratio of about 2.0 or more.
Other companies that might have high ratios include those that face little competition and therefore have strong market positions, and regulated companies, like utilities, that are considered to be relatively low risk.
Companies that don’t need a lot of debt to operate may have debt-to-equity ratios that are below 1.0. For example, the service industry requires relatively little capital, as labor may count as compensation for capital.
A debt-equity-ratio that’s high compared to others in a company’s given industry may indicate that that company is overleveraged and in a precarious position.
Imagine for a second that you have a mortgage, auto loans, and a high credit card balance, but you don’t have access to enough money to pay them off.
Not only will new lenders likely balk at extending you more credit, your debts might actually get the best of you. If you’re unable to pay your creditors, you might eventually be forced to declare bankruptcy.
A similar situation can occur for a company financing too much of their operations with debt, and can become a problem if they are unable to pay it back.
Investors may want to shy away from companies that are overloaded on debt. And not only that, companies with a high debt-to-equity ratio may have a hard time working with other lenders, partners, or even suppliers, who may be afraid they won’t be paid back.
In some cases, creditors will limit the debt-to-equity ratio a company can have as part of their lending agreement. Such an agreement prevents the borrower from taking on too much new debt, which could potentially limit the original creditor’s ability to collect.
It is possible that the debt-to-equity ratio may be considered too low, as well, which is an indicator that a company is relying too heavily on its own equity to fund operations.
Because the company isn’t taking advantage of potential growth opportunities, it may make investors less likely to want to get involved. Ultimately, businesses are trying to strike an appropriate balance within their industry between financing with debt and financing with equity.
Effect of Debt-to-Equity Ratio on Stock Price
The debt-to-equity ratio can clue investors in on how stock price may move. As a measure of leverage, debt-to-equity can show how aggressively a company is using debt to fund its growth.
The interest rates on business loans can be relatively low, and are tax deductible. That makes debt an attractive way to fund business, especially compared to the potential returns on the stock market. And sometimes an aggressive strategy can pay off.
For example, if a company takes on a lot of debt and then grows very quickly, its earnings could rise quickly. If earnings outstrip the cost of the debt, which includes interest payments, shareholders can benefit and stock prices may go up.
The opposite may also be true. If a company takes on a lot of debt and earnings don’t outpace the debt’s cost, then shareholders may lose and stock prices may fall.
Having to make high interest payments can leave companies with less cash on hand to pay for growth, which can also hurt the company and shareholders. And again, a high debt-to-equity ratio can limit a company’s access to borrowing more, which could limit its ability to grow.
Other Leverage Ratios
The debt-to-equity ratio belongs to a family of leverage ratios that investors can use to help them evaluate companies. These ratios are collectively known as gearing ratios. Here’s a quick look at other gearing ratios you may encounter:
Equity Ratio: This ratio compares a company’s equity to its assets, showing how much of the company’s assets are funded by equity.
Debt Ratio: This looks at the total liabilities of a company in comparison to its total assets. On the surface, this may sound the same as the debt-to-equity ratio. However, the total debt ratio includes short-term assets and liabilities as part of the equation, which the debt-to-equity ratio discounts. Also, this ratio looks specifically at how much of a company’s assets are financed with debt.
Time Interest Earned: This ratio helps indicate whether a company has the ability to make interest payments on its debt, dividing earnings before interest and taxes (EBIT) by total interest.
Most of the information needed to calculate these ratios can be found on a company’s balance sheet, save for EBIT, which can be found on a company’s profit and loss statement.
How Businesses Use Debt-to-Equity Ratios
Businesses pay as much attention to debt-to-equity as individual investors. For example, if a company is looking to take on new credit, they would likely want their debt-to-equity ratio to be favorable.
Banks and other lenders keep tabs on what healthy debt-to-equity ratios look like in a given industry. A debt-to-equity ratio that seems too high, especially compared to a company’s peers, might signal to potential lenders that that company isn’t in a good position to repay the debt.
Publicly traded companies that are in the midst of repurchasing stock may also want to control their debt-to-equity ratio. The reason is that share buybacks are usually counted as risk, since they reduce the value of stockholder equity. As a result the equity side of the equation is thrown and the debt side appears bigger.
The Limitations of Debt-to-Equity Ratios
Debt-to-equity ratio is just one piece of the puzzle when it comes to evaluating stocks. Whether the ratio is high or low is not the be all and end all of whether one should invest in a company. A deeper dive into how a company’s finances work and how it is structured may help paint a fuller picture.
In addition, a company’s accounting policies can change how the debt-to-equity ratio is calculated. For example, how a company includes preferred stocks—which have a higher claim to dividends—in its ratio can have a big effect. Preferred stock is sometimes included as equity, but it has certain properties that can also make it seem a lot like debt.
Specifically, preferred stock with with dividend payment included as part of the stock agreement can cause the stock to take on some characteristics of debt, since the dividends will have to be paid in the future.
If preferred stock is included on the debt side of the equation, a company’s debt-to-equity ratio can look riskier. If it’s included on the equity side, the ratio can look more favorable.
In some cases, assets and liabilities can be manipulated to produce debt-to-equity ratios that are more favorable. Additionally, investors may want to keep an eye on interest rates.
If they’re low, it can make sense for companies to borrow more, which can inflate the debt-to-equity ratio, but may not actually be an indicator of bad tidings. Finally, the debt-to-equity ratio does not take into account when a debt is due. A debt due in the near term could have an outsized effect on the debt-to-equity ratio.
As a result of temporary imbalances like these, investors may want to compare debt-to-equity ratios from various time periods to get an idea of what a normal range for a company might be, or whether fluctuations are signaling more noteworthy movement within the company.
Using the Debt-to-Equity Ratio
As an individual investor you may choose to take an active or passive approach to investing and building a nest egg. The approach investors choose may depend on their goals and personal preferences.
Investors who are comfortable with a passive, hands-off approach may want to invest through mutual funds, index funds, or exchange-traded funds, which provide a diversified portfolio through a basket of investments.
Investors who want to take a more hands-on approach to investing, choosing individual stocks, may take a look at the debt-to-equity ratio to help determine whether a company is a risky bet.
Though the debt-to-equity ratio provides information about the amount of risk and leverage a company has taken on, it isn’t the only pertinent piece of information.
And when adding an individual stock to a portfolio, it may be helpful to check if it fits in with your overall allocation and diversification plan.
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