MASTERCLASS Investing – What is Debt to Equity and how is it used by investors in analysing healthy companies to invest in?

MASTERCLASS Investing – What is Debt to Equity and how is it used by investors in analysing healthy companies to invest in?

Investing – What is Debt to Equity and how is it used by investors in analysing healthy companies to invest in?

When looking for financially strong companies to invest in, one fundamental ratio, Debt to Equity (D/E) gives us a measure of a company’s financial leverage (borrowings) 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.

The ratio formula is:

Debt to Equity =   Total Liabilities

                                 Total Equity

***Note – Sometimes only the interest-bearing, long-term debt is used instead of total liabilities in the calculation.

How It Works/Example:

Let’s assume Company ABC has:

  1. Total liabilities $10,000,000  and
  2. Shareholders’ equity of $20,000,000, and

then we can calculate Debt to Equity as: D /E = $10,000,000/$20,000,000 = 0.5 or 50%

This means that Company ABC has Debt that is 50% of shareholders’ equity.

Having a high debt/equity ratio generally means investors say the company has been aggressive in financing its growth with debt. However, this can result in volatile earnings as a result of fluctuating interest rates. 
But if debt is used to finance increased operations (high debt to equity), the company has the potential to generate more earnings than it would have without this outside financing.

The D/E ratio is also closely monitored by the lenders and creditors of a company, since it can provide early warning that an organization is too weighted by debt that it is unable to meet its payment obligations. There can also be a funding issue. For example, the owners of a business may not have/want to contribute any more cash to the company, so they acquire more debt to address the cash shortfall. Or, a company may use debt to buy back shares, thereby increasing the return on investment to the remaining shareholders.

To see what under 50% D/E can mean to a company, more examples with Telstra, and Buffet’s take on Debt, see our other article MASTERCLASS Investment – Debt to Equity explained

Want to learn the core issues of share investing? Our workshop Navigate to Successful Share Investinggives a 2.5 hour practical session to learn to easily understand Company Financial Statements, how to find healthy companies, what tools and ratios to use, work on examples, and also includes how to get better investment outcomes. Other Bonuses as well. Check the next one see Share WORKSHOP or call 0407 361 596

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