It takes money to make money, we know, but there are different ways a public company can access dollars to finance an expansion. Sometimes a business may use earnings or shareholders’ equity to fund growth, but it may also turn to debt, in the form of loans, to provide flexibility and predictability around the cost of capital.
Of course, there are two sides to every financing story, and too much debt can weigh on a business and ultimately impact its stock price. That’s why investors should have a sense of a company’s financial position before investing. One of the simplest ways to get a snapshot of a company’s level of indebtedness is the debt-to-equity ratio.
What is the debt-to-equity ratio?
The debt-to-equity ratio is a popular metric that provides a view into how much debt a company has taken on. The ratio divides the company’s total equity, or shareholder ownership in a company, less any debts and other liabilities, by its total debt. A company with a lot of debt may have a high debt-to-equity ratio and one with little leverage, a low one.
Importance of the debt-to-equity ratio for investors
In the same way a person can land in trouble if they take on more debt than they can afford, a company can find itself in hot water if it’s overleveraged. If a business has too much debt, it may not have enough cash to fund growth or pay dividends. If it can’t make its payments, it could file for bankruptcy — potentially leaving equity holders with nothing.
Generally speaking, companies with a high debt-to-equity ratio may be at a greater financial risk than those with a low one, and this can affect how attractive their stock is to investors. The ratio is most meaningful when comparing two or more stocks in the same industry and growth stage. While it’s a useful measure of financial health, it’s just one of several ratios you may consider before investing in a company.
How is the debt-to-equity ratio calculated?
The figures needed to calculate the debt-to-equity ratio can be found on the company’s latest balance sheet — sometimes called a statement of financial position or statement of assets and liabilities. The sum of all short-term and long-term debt (plus, if applicable, the current portion of long-term debt) is divided by the sum of all share capital and retained earnings. Expressed as an equation, it looks like this:
Debt-to-equity ratio = Total liabilities / Shareholders' equity
Many investing apps and websites will calculate a stock’s debt-to-equity ratio for you, but it’s best to double-check using the company's balance sheet if you are considering investing. There may be anomalies that are not readily accounted for using this formula.
Types of debt and equity
Debt represents bank financing, such as lines of credit and term loans shorter than one year, plus longer-term corporate loans and mortgages and corporate bonds issued to investors.
The equity portion of the ratio represents share capital — money raised from the sale of shares to investors, combined with retained earnings or the profit left over after covering all costs, including taxes.
How should I interpret the debt-to-equity ratio?
Finding a stock with a high debt-to-equity ratio compared to its peers could be a red flag, but not always. Here are a few ways to interpret that figure.
What is a good or bad debt-to-equity ratio?
When comparing two similar stocks, the one with the higher ratio may come with higher financial risk due to its increased debt load. For example, all things being equal, if Company A has a debt-to-equity ratio of 1.0 and Company B, a ratio of 2.0, Company B may be seen as riskier as it would have higher fixed financing charges that can reduce the cash flow available for earnings and dividends. In times of recession or high interest rates, companies carrying high levels of debt can also run a greater risk of insolvency. Debt can also be a good thing, as long as the company can pay off its loans. For instance, many companies borrow money to finance expansions, which can result in more revenue and earnings down the road.
What are the factors that affect the debt-to-equity ratio?
A company can change its debt-to-equity ratio, for example, by borrowing new money to complete an acquisition or by divesting an asset for cash. A company may also prioritize paying down debt with cash over investing in new capacity, boosting the dividend or buying back shares.
How can investors use the debt-to-equity ratio?
On its own, the debt-to-equity ratio may not be an especially useful tool for evaluating investments. That’s why it’s often used in combination with other metrics that track factors like earnings growth, value and momentum. Say you are a value investor and you like stocks with low price-to-earnings ratios. When you identify a stock with an attractive price-to-earnings ratio, you may also look at its debt-to-equity ratio. If it’s higher than those of rivals in the same industry, that may explain why the company is relatively undervalued. If the debt-to-equity ratio is in line with its peers, however, you may make a stronger case that the stock is a “buy.”
How does debt-to-equity compare with other ratios?
The debt-to-equity ratio is a high-elevation snapshot of a company’s financial position, but there are other liquidity measures, like the current ratio and the quick ratio, that can zero in on a company’s capacity to handle a short-term crisis.
- Current ratio: The current ratio indicates the firm’s ability to pay its current obligations from current assets (current assets to liabilities). Generally, a current ratio of 2.0 is considered to be good.
- Quick ratio: The quick ratio is similar, but more onerous, as it excludes inventory from current assets.
Modifying the debt-to-equity ratio
Financial analysts sometimes customize the debt-to-equity ratio to reflect other factors that are unique to the stock or the sector. For example, they may include total liabilities, which could include other amounts owing, such as tax, in the numerator. Total equity can also be determined by subtracting total liabilities from total assets. Whatever method you prefer, it’s important to use the same equation for all the companies being compared.
