MASTERCLASS Investment – Debt to Equity explained

Debt to Equity is one fundamental ratio to analyse a stock investment when searching for superior management, and can warn of potential risk.

Debt to Equity is a measure of a company’s financial leverage calculated by dividing its total liabilities by stockholders’ equity. It indicates what proportion of equity and debt the company is using to finance its assets.

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation. Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as companies’.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

A study of stocks on the ASX showed that companies that had debt to equity below 50 percent outperformed companies that had debt to equity above 50 percent by an average of 6.75 percent per year. Getting rid of stocks with a high debt is part of the process in turning a risky, low performing portfolio into a stable, high-performing portfolio.

Take a look at Telstra – at the end of 2009 financial year the debt to equity ratio was 139.5 percent meaning that for every $100 of equity, the company owes $139.50.

On the bright side, the debt has come down slightly for the most recent financial year. it is now 117.4 percent. However, analysis of the financial statements for Telstra shows that the costs of servicing this debt has risen from $967 million to $1,030 million. Admittedly this is a small increase compared to the reduction in debt.

But it highlights the risks associated with high levels of debt. The company has no control over interest rates and any increases can severely the curb the profitability, even the viability, of the company.

Quoting Buffett, he says “Debt is a four-letter word around Berkshire.” A level where the debt to equity ratio is above 50 percent is usually a risky proposition.

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