Debt-to-Equity Ratio

One of the more important stock terms to read up on is the debt-to-equity ratio. This ratio can tell you at a quick glance the general financial practices of the company, and it is one of the ratios used most often in stock analysis. For that reason, the debt-to-equity ratio is pretty darned important, and we should spend a little time going over the details.

What Exactly is the Debt-to-Equity Ratio?

Basically, the debt/equity ratio calculates the amount of debt a company carries as compared to the stockholders’ equity. So, in essence, the company balance sheet shows how much debt they carry and how much equity they hold. When you divide the debt (aka liabilities) by the equity, you get a nice clean number that can be used as an indicator of how aggressive the company is about taking out debts to fund purchases of assets.

What Does it All Mean?

Of course, just knowing the practical mathematics behind calculating the debt/equity doesn’t help much. We have to go a little deeper. So here it goes:

Typically, companies will fall into natural debt/equity ratios for their industries. For example, companies in the personal computer industry often have a low debt/equity ratio of 0.5 or below while manufacturing industries run higher, at an average of above 2. This generally means that the manufacturer must hold larger assets to keep business running (like owning heavy machinery and larger warehouses); it does not mean the manufacturer is in poorer health than the computer company.

For you, as an investor, it’s therefore important to note the debt/equity ratio as a comparison to the average ratio in the industry. This helps you determine if the debt/equity ratio of a company in which you are interested in purchasing stock is normal, which often indicates that the company handles their cash well. On the other hand, if the debt/equity is higher than normal ,this could be an indication that the company is either in trouble (and is taking on loans to stay afloat) or that it is being very smart about making purchases that could help the company advance.

How Do I Know if a Frog is a Prince?

This begs the question: how do I know if a company is failing or being smart? In this case or in the case of any elevated debt/equity ratio, it’s important to look at other factors that indicate the company’s general health. Look back on how well the company has fared and how steady their returns have been over a few years.

Research any news about the company. Taking a look at the bigger picture can help you understand if the company is on the brink of failure and trying to stay afloat or if they are making a smart investment into additional assets that can drive the company (and your returns) forward in the future.

So that’s it: all the general know-how you need about the debt/equity ratio! Join us in the weeks to come as we continue to define stock terms and general finance terms.

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