The debt-to-equity ratio is an essential metric to understand for anyone looking to invest in the stock market. This is especially true when it comes to owning companies, rather than shares of a fund.
Owning individual companies in your portfolio tends to require more research than mutual funds or a basket of ETFs. After all, the amount of risk involved with owning individual stocks is higher, to a degree, than the funds that provide you with instant, automatic diversification.
If you believe in fundamental analysis, researching a company involves a metaphorical walkthrough of the company from the bottom-up. Often times, this involves looking into a company’s:
And, once you get into a company’s financials, you’ll be dealing with one of the most important financial statements in any industry: its balance sheet.
The balance sheet provides you with a breakdown between the firm’s assets and liabilities. Using the information found on this document, you can calculate all manner of ratios and financial information, including the debt to equity ratio.
After reading this article, you’ll understand what the debt to equity ratio is, how to calculate it, and what it means to you as an investor.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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What Is Debt To Equity?
The debt to equity ratio measures how levered a company is. In other words, it determines how much of the firm relies on debt to finance its operations.
Investors often like to know this before they get financially involved with a company. This allows them to measure how much risk the company is exposed to and whether it would be a good fit for their portfolio.
To calculate a company’s debt to equity, you use the following calculation: (Total liabilities / Total shareholders equity)
In this formula, total liabilities refer to the short- and long-term debt a firm carries on its balance sheet. This may represent a combination of long-term bonds in addition to other financing.
Total shareholders equity is the number you get when you subtract total liabilities from a company’s total assets.
For example, if The Awesome Company has $1 billion in total liabilities and $2 billion in shareholders equity, the company would have a debt to equity ratio of 0.5.
When it comes to interpreting the result: the higher the ratio, the more leveraged the company is. And, the more leveraged a company is, the riskier it is.
Why Do Companies Take On Leverage?
Different companies finance their operations differently. A particular company may use its debt to finance:
- New facilities
- New projects
- Research and development
- Mergers and acquisitions
Additionally, when you’re looking to compare a company’s debt to equity against its industry, it’s important to keep in mind that each industry has its own standard for how much debt it uses to finance operations.
For instance, the energy and telecom sectors have been known to use leverage, since they typically offer steady cash flows. In turn, this allows the companies to service their debt appropriately.
Moreover, it’s also common to see aggressively-scaling companies use a lot of debt to grow. It’s especially common to see smaller growth companies use this practice. This is why these types of companies are prime bankruptcy candidates during recessions.
As such, if you take a deep dive into a company’s balance sheet, it may be worth seeing how a company is using its debt and asking some important questions, such as:
- Is the usage of debt reckless or strategic?
- What is the return on investment from using the debt?
- Why is the company using debt instead of assets to finance operations?
Furthermore, before deciding if a firm has too high or low of a debt to equity ratio, make sure you compare it to other companies in its industry. You’ll also want to make sure you have a basic understanding of what the industry standard is for an accurate comparison.
After all, comparing apples to apples is very important in fundamental analysis.
Tweaking the D/E Ratio
It is not uncommon to see analysts make adjustments to the Debt to Equity ratio in order to get a more “contextual” picture of the company’s current level of leverage.
One way that the D/E ratio can be manipulated is by including the firm’s preferred equity. This can be added to the numerator or denominator if you are looking to compare the capital structure of two different firms.
The main thing to keep in mind is that you want to be consistent with the placement of the preferred equity in the equation. As you do with one, you must do with the other.
Another thing that analysts may do is remove short-term debt obligations from the “total liabilities” portion of the equation. This is done to focus more on the debt that tends to carry more risk for the firm, the long-term debt.
Again, when doing this with one company, make sure you do it for the other company’s ratio. Comparing apples to apples is crucial when performing fundamental analysis.
Shortcomings of D/E
Like any other financial ratio, debt to equity does not provide you with a full picture of a firm’s financial state. Nor does it necessarily indicate how the firm will perform in the future.
From an accounting perspective, there may also be varying degrees of how a company or analyst determines an “asset” versus a “liability.”
Thus, if you are very serious about what’s going on behind the curtain, you may want to dig deeper into how analysts calculated a particular firm’s debt to equity ratio. It’s not uncommon for two analysts to break down the same balance sheet and come out with different ratios.
Also, it’s important to remember that this ratio varies significantly between industries. Those that have strong, consistent cash flows are known to use debt to finance operations. While this allows them to avoid using up their assets to service their liabilities, it can skew the “average” debt to equity ratio from other industries.
Where Can I Find More Information?
In today’s world, investors can find all of the major financial ratios for a company through a quick Google search.
Sites like Yahoo Finance often show information on a company’s balance sheet for free. All you have to do is look under the “Financials” tab. From there, you can look up the company’s most recent balance sheet information.
Other services, like Morningstar, tend to provide the ratio for you on their research reports.
There is no right or wrong way of finding this information, as long as the source is reliable.
A Final Word
Understanding a firm’s capital structure is a crucial first step when performing fundamental analysis on a company.
Debt in and of itself is not necessarily a bad thing. Leverage, is used within reason, can help a business scale operations more aggressively. And, by taking out debt, a company won’t have to use assets or issue more stock, thereby diluting shareholder equity.
However, if a company mismanages its debt obligations, it may find itself in trouble. This is especially true when the economy takes a turn, such as during a recession or periods of instability.
Your role as an investor is to understand how much financial risk a company exposes itself to – and decide whether or not you’re comfortable adding that risk to your portfolio.
Furthermore, when in the decision-making process, it’s essential to company capitalization structure within the same industry. This will give you a more contextual picture of how a firm is leveraged relative to its competitors and peers.
Also, you want to make sure you look for what an analysis considers in deriving the ratio. Did they alter the “total liabilities” component? How? Why? Does the company have preferred equity? How is this incorporated into the equation?
The good news is that all of this information is easy to obtain in today’s world, especially when compared to just a few decades ago. Nowadays, anyone with a basic understanding of these subjects can begin making rational decisions with data found at their fingertips.
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