A debt-to-equity ratio is one of the metrics you can use to evaluate a company’s health—specifically, whether or not the company is standing on stable financial ground.
What is a good debt-to-equity ratio? And how can you use the debt-to-equity ratio to guide your investment choices?
What is A Debt-to-Equity Ratio?
The debt-to-equity ratio (also known as the “D/E ratio”) is the measurement between a company’s total debt and total equity.
In other words, the debt-to-equity ratio tells you how much debt a company uses to finance its operations.
For instance, if a company has a debt-to-equity ratio of 1.5, then it has $1.5 of debt for every $1 of equity.
If you’re new to investing, then it might help to get familiarized with the following terms:
- Assets: What a company owns—cash, properties, equipment, etc.
- Liabilities: What a company owes on its unpaid debts—loans, bonds, etc.
- Equity: The value of a company’s assets, minus its liabilities.
You can find a company’s debt-to-equity ratio on the company balance sheet.
Debt-to-Equity Ratio vs. Gearing Ratio
Both the debt-to-equity ratio and gearing ratio are used to evaluate a company’s financial health. The debt-to-equity ratio measures the amount of debt a company holds compared to the amount of equity it holds. The gearing ratio is more focused on leverage. This means taking more financial risks into consideration, including fixed interest and dividend-bearing funds.
Why is the Debt-to-Equity Ratio Important?
Debt repayment can be a major financial strain on a business and significantly reduce its profit margin. You probably have your own experience with debt if you’ve ever taken out a mortgage, financed a vehicle, or received student loans. You’re probably well-aware of how those debts impact your checking account.
Debt is inherently risky. And, for businesses, it presents a mortal danger during an economic downturn. Recessions can damage a company’s cash flow, making it harder for the company to repay its outstanding debt and putting the business at greater risk of bankruptcy.
Many investors prefer to buy into companies that have a low debt-to-equity ratio. A company with fewer debts is less risky.
Let’s flip the tables and view the debt-to-equity ratio from a company’s perspective. If you’re a business owner, a high debt-to-equity ratio could impact your ability to get financing from creditors. For example, if you own a real estate company, a high debt-to-equity ratio could discourage lenders from giving you a mortgage loan. So the debt-to-equity ratio is an important number, whether you’re an investor or a business owner.
However, high debt is not necessarily an indicator that a company is struggling. Some investors prefer a higher debt-to-equity ratio. Some companies use debt to stimulate growth, in which case investors reap high returns if the growth plan is successful. We’ll discuss this in more detail.
Debt-to-Equity Ratio Formula
You can calculate the debt-to-equity ratio by dividing a company’s total liabilities by its shareholder equity. Here’s the debt-to-equity ratio formula:
- Total Liabilities / Total Shareholder Equity = Debt-to-Equity Ratio
Let’s try it out. If a company has $120,000 in shareholder equity and $30,000 in liabilities, then:
- $30,000 / $120,000 = 0.25
You can also use this formula to calculate the debt-to-equity ratio of your personal finances.
What is A Good Debt-to-Equity Ratio?
Generally, a good debt-to-equity ratio is anything lower than 1.0. A ratio of 2.0 or higher is usually considered risky. If a debt-to-equity ratio is negative, it means that the company has more liabilities than assets—this company would be considered extremely risky. A negative ratio is generally an indicator of bankruptcy.
Keep in mind that these guidelines are relative to a company’s industry.
In some industries, businesses may tend to have higher debt-to-equity ratios, while the average debt-to-equity ratio is lower in other sectors.
For example, the finance industry (banks, money lenders, etc.) typically has higher debt-to-equity ratios because these companies leverage a lot of debt (usually when granting loans) to make a profit.
On the other hand, the service industry has lower debt-to-equity ratios because they have fewer assets to leverage.
How to Use a Debt-to-Equity Ratio
As mentioned earlier, a high debt-to-equity ratio isn’t necessarily a bad thing. Some investors may prefer to invest in companies that are leveraging more debt. Furthermore, high debt is commonplace in certain industries.
You shouldn’t make an investment decision based solely on the debt-to-equity ratio. But you can use the debt-to-equity ratio to evaluate the financial prospects of a company.
When you’re doing stock research on a company, ask yourself the following questions:
- What is the Average D/E Ratio for the Industry?
- How is the Company’s Cash Flow?
- How is the Company Using Its Debt?
- Assume the Worst
- What’s Your Risk Tolerance?
1. What is the Average D/E Ratio for the Industry?
Once you’ve found the debt-to-equity ratio for a prospective investment, compare it with other companies in the same industry. See whether or not the company’s D/E ratio is close to the industry average.
2. How is the Company’s Cash Flow?
Even if the company’s D/E ratio is far above the industry average, we still have an incomplete picture of its overall financial health. You’ll want to check the other financial data included in the company’s financial statements (be sure to check out FortuneBuilders’ guide on how to do stock research if you’re unsure of how to use these statements).
Determine whether or not the company is turning a profit through its central business. Even if a company has a large amount of outstanding debt, strong profits could enable the company to pay its bills every month.
3. How is the Company Using Its Debt?
Debt isn’t always a bad thing—and, in some cases, it’s the only feasible way for a business to grow. If you’re thinking about investing in a company that has a higher debt-to-equity ratio, make sure that the company is using the debt to create lasting growth. You’re making sure that the company has a solid growth plan.
But how do you know whether or not a growth plan will be successful?
You can’t be 100% certain. You’ll have to use your insight and knowledge of the industry (this is why most investors advise you to invest in companies/industries you know very well).
Consider the following:
- Feasibility: Does the growth plan employ a sound business strategy? Is it putting the debt to good use?
- Durability: You don’t want your investment funding an inferior product or a misguided expansion into a new market. You also don’t want your investment funding a growth spurt that will flame out after a short period—the growth needs to provide enough profit to help the company pay back the money borrowed for its expansion.
It doesn’t matter whether the company is leveraging debt by taking a loan, issuing bonds, or issuing new shares. If the company doesn’t plan for how it will leverage the debt—or if the debt is being used for unhelpful purposes, consider it a red flag.
4. Assume the Worst
Before you invest in any company, always imagine a worst-case scenario in which there’s a major economic downturn that significantly hinders a company’s profits.
Ask yourself: if the company’s revenue decreased by 30%-50%, would it prevent the company from paying its debt?
Remember that the Great Recession brought misfortune to many businesses—especially financial institutions, which tend to have higher debt-to-equity ratios. Don’t ever evaluate the health of a company by its peak performance. Always assume that the economy could swing downward.
5. What is Your Risk Tolerance?
Last but not least, consider your own risk tolerance. Are you comfortable investing in a company that has a higher debt-to-equity ratio? Or would you prefer investing in a safer company that has less debt?
Many companies leverage a large amount of debt to create strong, long-term growth—and investors who buy in early could potentially reap high, above-the-market returns.
The company could also fail to pay off the debt and go into bankruptcy—providing shareholders with a significant loss.
Making Your Decision
There’s nothing wrong with taking the safe route, especially if you’re a long-term investor who’s trying to save for retirement or create a passive income. If you plan to invest in a company with more debt, ensure that you have a diversified investment portfolio and restrict a smaller percentage of your portfolio to these high-risk stocks.
Long-Term Debt-to-Equity Ratio
The debt-to-equity ratio is greatly skewed by long-term debt. Long-term debt tends to be more expensive and involves a larger sum of money. Although larger debts tend to be riskier, they’re also capable of generating the most growth.
Long-term debt is mostly used to:
- Fund expansion and acquisition
- Raise capital when the market has low interest rates
- Buyback stocks (to improve the value of the remaining shares)
If you’re a short-term investor (i.e., you plan on holding company stock for only a year or two), you might want to avoid using any metric that accounts for long-term debt. Here are a couple of alternative ratios you can use:
- Cash Ratio: Measures the company’s liquidity. [ (Cash + Marketable Securities) / Short-Term Liabilities = Cash Ratio ]
- Current Ratio: Measures the ability of a company to pay short-term obligations within one year. [ Short-Term Assets / Short-Term Liabilities – Current Ratio
