In a company’s capital structure, they can borrow money in two ways. One way is to take out loans and other lines of credit. The other is by issuing shares to institutional investors who allow them to be publicly traded. When you're looking to invest in a company, an easy form of fundamental analysis you can look at is how much debt a company has and how much equity it has. These two simple items, which can be found on a company’s balance sheet, combined with comparing it to other companies in the same sector paint a picture of a company’s debt-to-equity ratio.
In this article, we'll define what the debt-to-equity ratio is and how to calculate it using examples. We'll also review how to interpret the debt-to-equity ratio in fundamental analysis, the role of debt in a company's capital structure, and finally the limitations of the debt-to-equity ratio which can show why two companies with similar financials can post different debt-to-equity ratios.
What is the debt-to-equity ratio?
A company’s debt-to-equity ratio is a performance metric that measures a company’s level of debt in relation to the overall value of their stock. The debt-to-equity ratio is expressed either as a number or a percentage and allows investors to compare how much of a company’s assets and potential profits are being leveraged by debt. The debt-to-equity ratio is easy to calculate since all the information needed to make the calculation can be found on a company’s balance sheet.
Companies use debt precisely because of the idea that financing via debt is typically less expensive for a company as opposed to obtaining equity financing by issuing new shares. In addition to being less expensive, debt financing is used precisely because it does allow a company to use leverage, which can increase the value of a company through the use of borrowed money.
How to calculate debt-to-equity ratio.
The calculation for debt-to-equity ratio is as follows:
Debt-to-equity ratio = Total liabilities/equity
In cases where a company's capital structure combines both debt and shareholder equity, the equity will be shareholder's equity. This is because, on a company's balance sheet, their liabilities and shareholder's equity must be equal to their assets. For example, at the end of 2014, Apple, Inc. had a balance sheet that showed total liabilities of $120,292 billion and total shareholders' equity of $111,547 billion.
Their debt-to-equity ratio would be:
120,292/111,547 = 1.07– which means that they have slightly over $1 of debt for every $1 in shareholders’ equity.
For smaller businesses, equity will refer to the difference between assets and liabilities. Let's look at two examples. If Company XYZ has $300,000 in assets and $250,000 in liabilities, they would have $50,000 in equity (300,000 – 250,000 = 50,000). Then calculate the debt-to-equity ratio using the formula above:
Debt-to-equity ratio = 250,000/50,000 = 5 – this would imply the company is highly leveraged because they have $5 in debt for every $1 in equity.
Another small business, company ABC also has $300,000 in assets, but they have just $100,000 in liabilities. Their equity is 300,000 – 100,000 = 200,000. Their debt-to-equity ratio is:
100,000/200,000 = 0.5 – this suggests that the company has a healthy balance sheet since they have $2 in equity for every $1 in debt.
Understanding debt-to-equity ratio in fundamental analysis.
The debt-to-equity ratio is one of the common tools that investors will use in fundamental analysis. This is because a high degree of leverage can create problems for a company if their revenues decline. In that case, they would have to pull money out of the business to finance their debt.
Interpreting the debt-to-equity ratio is straightforward. A company that has a debt-to-equity ratio of 1 means that they have $1 in debt for every $1 in shareholders’ equity. If a company has a high debt/equity ratio it is generally said that the company is taking on a high level of risk. Since, unlike equity, debt obligations have to be repaid with interest, a company with a high level of debt can be subject to higher interest rates which can add volatility to their earnings and their stock price.
A company with $50 billion in total liabilities and total shareholders’ equity of $15 billion would have a debt-to-equity ratio of 3.33 or 333%. On the contrary, a company that has total liabilities of 27 billion and total equity of $120 billion would have a debt-to-equity ratio of 0.225 or 22.5%. A simple comparison of the two companies shows that the company with a 333% debt-to-equity ratio is more highly leveraged than the company with a 22.5% debt-to-equity ratio.
From a fundamental analysis standpoint, is a relatively high debt-to-equity ratio bad? The answer depends on how the company is using the money it receives. Infrastructure or process improvements that are achieved by the use of debt can significantly increase a company’s earnings. If the increase in earnings exceeds the amount of interest that a company pays to service their debt, then existing shareholders will benefit because the higher earnings are being divided among a shareholder pool that has not increased. However, if the interest payments on the debt are higher than the increase in earnings, then the market value of the company could take a hit as could the share price. In the worst case scenario, if a company’s cost of debt becomes too much to handle, the company may have to file for bankruptcy. This is the worst outcome for shareholders who, unlike creditors, have no legal claims to a company’s assets in a bankruptcy.
The role of debt in a company’s capital structure.
In personal finance, debt has become a bad word, and after the financial crisis of 2007, there is some reason for that. Consumers who took on too much debt whether that was in the form of credit card debt or mortgages financed at subprime rates by questionable lenders created a debt spiral that the country is still exiting.
In business, however, analysts look for companies to have a certain amount of debt. Debt is generally less expensive for a business in comparison to equity. Although a company is not obligated to pay back the money it receives from shareholders, investors who contribute capital to a company in the form of buying shares have an expectation of a return, known as the cost of equity. Debt, while requiring repayment, can generally be financed at an interest rate that is far below an investor’s expected cost of equity. The interest a company pays on its debt is also tax-deductible which adds to its appeal.
In fact, the absence of debt can be seen as a sign that either the company is holding on to too much cash or they are inefficiently financing their debt using shareholder equity. In the case of holding too much cash, it may mean that a company is being too conservative and missing opportunities to grow their business. In the short term, their balance sheet will look good, but in general, too much cash is largely seen as a problem. On the other hand, equity can be expensive because of the expectations it places on a business. The first expectation comes in terms of return on equity. That is a measurement of how much profit a company generates for each dollar it receives from shareholders. The second metric a company will use is cost of equity. As we mentioned above, an investor has a cost of equity in mind. So too does a company who will be asking themselves how much of a return they can expect to make it profitable to fund the project using investor equity.
How accurate is the debt-to-equity ratio?
Like a lot of financial metrics, the accuracy of the debt-to-equity ratio is only as accurate as the data that’s entered. When you look at a how an analyst defines debt-to-equity ratio, many times it is not as simple as looking at “total liabilities” and “total shareholders’ equity”. In many cases, analysts will not include such liabilities as convertible debt, accounts payable, accrued liabilities and leases, or other contractual obligations. When this is the case, the debt-to-equity ratio can look more positive than it may otherwise be. Another potential area of disagreement is the issue of deferred taxes. In many cases, these are not included as a debt component although realistically they may never have to be paid and therefore could be considered part of a company’s base capital.
When looking on the equity side, preferred stock will sometimes be removed from the equity side and added to the debt side. The reasoning is that preferred stock comes with the expectation of a dividend payment.
Another consideration is the type of industry the company is in. In general, an industry like manufacturing that is very capital intensive (i.e. it requires plants and equipment) will have a higher debt-to-equity ratio than a business such as environmental consulting or IT consulting that is not as capital intensive. For this reason, it’s always good to compare the debt-to-equity ratio of a company with a competitor in the same sector.
The bottom line on debt-to-equity ratio.
Every investor should have the expectation that a business will grow. For an investor, a company that increases their earnings is likely to show an increase in share price. However, for a company to take on the projects that can lead to the kind of growth it needs, they will require additional capital. That capital will come from one of two sources: debt or equity. When looked at together, investors can calculate a ratio called the debt-to-equity ratio which is helpful to understand a company’s capital structure and the degree to which it is leveraged.
In simplest terms, the calculation for debt-to-equity ratio is:
Debt-to-equity ratio = total of current liabilities/total of shareholders’ equity
Both of these numbers can be found on a company’s balance sheet. When looking at the debt-to-equity ratio, assets do not need to be considered because the total of current liabilities + shareholders’ equity has to balance the amount of assets a company has.
So if a company has $400,000 in liabilities and $200,000 in shareholders’ equity it would have a debt-to-equity ratio of 2 or 200%. This means they have $2 of debt for every $1 in shareholder capital.
This would be different for a company that did not have shareholders. In that case, equity is simply calculated as:
Total assets – total liabilities = Equity
That equity number would then be used in the initial calculation. This might be seen in a small business that is looking for a bank loan. If they have $200,000 in assets and $75,000 in liabilities, their equity would be $125,000. Their debt-to-equity ratio then would be:
75,000/125,000 = 0.6 or 60%. This would be considered a company with low risk.
Debt can be a useful way for a company to finance projects since the interest rate they will pay is less than the cost of equity expected by investors. If the interest rate they pay is less than the increased earnings they can generate, shareholders will profit by having those higher earnings spread out among a shareholder base that remains the same. This is in contrast to equity financing, which will increase the shareholder base.
In general, a lower debt-to-equity ratio is better than a high one, but other factors can weigh into this when evaluating a company using fundamental analysis. In the case of an investor, they should compare the debt-to-equity ratio of similar companies and also seek to find what debts and equity were used to calculate the ratio since some analysts may choose to include some items and exclude others.
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