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:
***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:
- Total liabilities were $10,000,000; and
- 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, his 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 why 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
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