Wednesday, May 21, 2008

Stock Analysis - Debt To Equity Ratio

What is debt to equity and how can it help beginners when investing in the stock market?

A company's debt to equity ratio or it's gearing ratio is a measure of the level of borrowings a company has used in proportion to stockholders' equity to finance it's assets. It's often used as an indicator of the amount of risk inherent in the shares of a particular corporation.

How To Calculate Debt To Equity:

In it's simplest form, the debt to equity ratio formula is as follows:

Debt To Equity = Total Liabilities / Stockholders' Equity

While there are many variations on this basic formula, I find this one to be easy and convenient to apply. Both these figures are readily available in the Balance Sheet contained in a company's published Financial Statements. Variations are mainly around what is included in the Total Liabilities. I've seen some analysts subtract cash on hand from total liabilities or leave working capital out altogether.

The only major difference is when gearing is measured as debt to total assets (or debt / (debt + stockholders equity). Using these figures will normally give a materially different result. The reason I mention this is that gearing ratios and debt to equity ratios are sometimes used interchangeably and you need to understand whether gearing is being quoted as debt to equity or debt to total assets.

Why Do We Care About This?

I mentioned earlier that it can be used as an indicator as to riskiness of a stock market investment. Normally a company with more borrowings is seen as being more risky than a company with less. This is because these loans, or more specifically, a company's ability to service it's theses loans, is key to it's survival. If a corporation fails to pay interest on borrowings on time or is unable to repay the principal when it falls due, it's creditors' may move in. In the worst case scenario, insolvency could result and that could lead to significant or even total loss of capital for investors.

So why do companies borrow money at all? It's not all doom and gloom. When managed correctly, gearing can be used to help grow a business, leverage shareholders' capital more efficiently and ultimately increase returns to shareholders. If a business can borrow money at 7% and generate a return of 10% on those funds, the excess earnings will accrue for the benefit of holders of the company's stock. This means higher profits and more money to invest in growing the business or to pay out as dividends. That's why the use of borrowed money is sometimes described as leverage.

But, interest rates vary over time and corporate profits fluctuate with the business cycle. What happens when interest rates rise? Can the company still meet it's interest obligations? And similarly, as the economy slows and cash flow drops, can its loans still be serviced. The recent (ongoing?) sub prime crisis also illustrates what happens when borrowings fall due and companies are unable to refinance. All of this illustrates why I prefer to invest in the stock of companies who use borrowed money conservatively.

What Is A Good Debt To Equity Ratio?

As with much of what goes with investing in the stock market, there is no hard and fast rule here. It will depend on the company and on the industry in which it operates. Capital intensive businesses will tend to have higher debt to equity ratios. Businesses that have reliable earnings (ie. earnings which don't fluctuate much through economic cycles) like utilities and consumer staples can normally sustain higher gearing ratios as well.

You could apply a rule of thumb and say you'll steer away from businesses whose debt/equity ratio is greater than 1 (ie. it's financed more through borrowings than through stockholders' equity) but you may exclude some industries altogether. However, this may not be a bad thing as some may argue that corporations which require large amounts of borrowed funds probably don't have very strong businesses - I believe Warren Buffett is said to prefer the stock of companies with low levels of borrowing. When looking for prospective investments, I look at a company's debt to equity ratio over time and also compare it against other companies in the same industry.

Another useful stock market ratio is interest coverage or times interest earned. It measures a company's ability to service it's loans. The higher the coverage the better - there's more leeway if things turn sour. I'll write more about this in an upcoming post.

Some of my biggest mistakes in my early beginner attempts at investing in the stock market were the result of high debt. That's why I always consider debt to equity as part of my stock analysis.

Update: I've since written a post on the Quick Ratio, another useful indicator of the financial health of prospective stock market investments.


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Parag said...

Leverage can be good because it can decrease a firm’s cost of capital but too much debt can be dangerous. It is safest to look for firms with no more debt than equity so that their debt-to-equity ratio is less than 1.
debt to equity ratio

sanjeev said...

Calculate your debt to equity ratio on a quarterly basis. The first financial information you will need to calculate is your company's entire debt. This includes all debts that the company owes. Typically these are divided into short term debts and long term debts on your financial statements. You will need to combine both of these categories to come up with the total debt of your company.

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Excellent advice on a very important metric on stock investing. I myself like to look at the interest expense thats how much of a companies cash flow must go to pay interest on bonds or bank loans.

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Always a bad idea to invest in leverageed companies