What is debt-to-equity ratio? |Debt-to-equity ratio formula |What is a good debt-to-equity ratio? | What is a high debt-to-equity ratio? | Importance of debt-to-equity ratio | How to use debt-to-equity ratio |Debt-to-equity ratio example | How to lower debt-to-equity ratio
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 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 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.
What Is A High Debt-To-Equity Ratio?
When it comes to calculating ratios, it’s not just about knowing the formulas or how to calculate them. Because the resulting numbers are relative, you’ll also need to have an understanding of what is considered too low or too high. Sometimes you’ll seek a relatively now number, while other times you’ll seek a high number.
When it comes to debt-to-equity, you’re looking for a low number. This is because total liabilities represents the numerator of the ratio. The more debt you have, the higher your ratio will be. A ratio of roughly 2 or 2.5 is considered good, but anything higher than that is considered unfavorable. A ratio between 5 and 7 enters the “high” zone.
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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 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 its equity. The gearing ratio is more focused on leverage. This means taking more financial risks into consideration, including fixed interest and dividend-bearing funds.
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. Ann Martin from CreditDonkey adds that “debt-to-equity ratio is used to measure the financial health of a company. A company with a high debt-to-equity ratio would have a hard time paying off its outstanding debts in the event of a downturn. It isn’t necessarily a problem for short periods when business is good, but it’s not a good long-term situation for a business to be in”.
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 with a higher debt-to-equity ratio, make sure that the company uses 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.
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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
Debt-to-Equity Ratio Example
Perhaps you are interested in clean energy and automobiles, and you are inspired to consider investing in Tesla.
[Note: FortuneBuilders does not advocate that you should/should not invest in Tesla. This is just an example.]
Let’s walk through the process of how you’d use the company’s debt-to-equity ratio to make an investment decision.
The company holds $16.89 billion in shareholder equity and $10.61 million in liabilities, so the debt-to-equity ratio is 0.63.
First, let’s compare that to other debt-to-equity ratios in the automaker industry (figures from September 2020):
General Motors: 1.70
Tesla has a great debt-to-equity ratio, and it’s lower than some of the other automakers. But the debt-to-equity ratio doesn’t tell the whole story. Let’s consider the following:
How is the Company’s Cash Flow?: Tesla’s revenue has been steadily increasing for the past 12 months ($28.176 billion)
How is the Company Using Its Debt?: After the strong earnings report in September 2020, Tesla founder Elon Musk says that the company will spend more money on building new factories and expanding into foreign markets, especially in China.
Assume the Worst: The pandemic-ravaged economy in 2020 is a worst-case scenario for many investors. Nonetheless, Tesla has boasted impressive earnings. But even if revenue dropped by 50% (to about $14 billion), the company’s $16.89 billion in shareholder equity would cover outstanding debts.
What’s Your Risk Tolerance?: You have low risk tolerance. But Tesla’s low debt and steady earnings appear safer than other companies.
From all the information we’ve gathered, you decide that Tesla is a reliable and relatively safe investment. The decision wasn’t based solely on the debt-to-equity ratio, but the ratio helped us put together the company’s bigger financial picture.
How To Lower Your Debt-To-Equity Ratio
As a business owner, a low debt-to-equity ratio can go a long way in terms of securing financing when needed, working with lenders, or even improving your business credit. But, how exactly do you lower your debt-to-equity ratio?
The most obvious answer is to pay down your loans and generate more income. Focus your payments on reducing debts and increase your profitability where you can. This will typically involve reevaluating your business budget and cutting operational costs, but it can be done.
In the meantime, there is another option: restructure your existing debt. Look into refinancing options with more forgiving payback periods and interest rates. This could greatly reduce the amount of money you owe overall while you work on improving business operations.
As you make repayments, your debt-to-equity ratio will start to even out. Try not to apply for additional loans that could counteract the work you are doing. In time, you can lower your debt-to-equity ratio and boost your bottom line.
The debt-to-equity ratio measures how much debt a company is using to finance its operations. So, what is a good debt-to-equity ratio? A higher debt-to-equity ratio indicates that a company has higher debt, while a lower debt-to-equity ratio signals fewer debts. Generally, a good debt-to-equity ratio is less than 1.0, while a risky debt-to-equity ratio is greater than 2.0. But this is relative—there are some industries in which companies regularly leverage more debt. The debt-to-equity ratio by itself won’t give you enough information to make an educated investment decision. Still, it can help you determine a company’s financial health and future risk.
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The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only.