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Whether you are looking at investing or just want to get a better handle on finances, there are a lot of important terms to know. One of these terms is the debt to equity ratio. This is also called the debt/equity ratio, D/E ratio or simply referred to as “risk.” To help you with your investment and financial terminology, let’s take a look at the share market basics for beginners, and what this ratio is, what it means, how to calculate it and the importance of understanding a long term debt to equity ratio.
What is a Debt to Equity Ratio?
A debt to equity ratio compares a company’s total debt to total equity, as the name implies. What this means, though, is that it gives a snapshot of the company’s financial leverage and liquidity by showing the balance of how much debt versus how much of shareholders’ equity is being used to finance assets.
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Typically, the result of this calculation is stated as a percentage. A low debt/equity ratio means lower risk to investors, since it means there is less debt relative to the available equity. A high debt/equity ratio translates to higher risk, since there may not be enough available equity from shareholders to fulfill obligations in the event of a financial decline.
How to Calculate Debt to Equity Ratio
Debt to equity ratio is simple to calculate and is represented by this equation:
Debt/Equity Ratio = Total Liabilities ÷ Total Shareholders’ Equity
This ratio can then be used to help investors identify the level of risk associated with different companies and their financial stability. It is important to know the industry standards of the company, since different industries have differing amounts of capital and income streams required in order to operate. In some industries, it’s more common and acceptable to have a higher debt to equity ratio than others.
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Long Term Debt to Equity Ratio
The long term debt to equity ratio is the same concept as the normal debt/equity ratio, but it uses a company’s long term debt instead. Like the other version of this ratio, it helps express the riskiness of a company and its leverage. Long term debt includes:
– Mortgages on company property
– Corporate bonds
– Business loans
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How to Find Total Equity from Debt to Equity Ratio
To find the total equity from debt/equity ratio, just divide the Total Debt by the Debt/Equity Ratio.
For example,
Total Equity = Total Debt / Debt to Equity Ratio
In normal situations, you may not find the need to calculate total equity from debt to equity ratio, but this is good to know for back of the envelope calculations or accuracy checking your analysis.
Value Investing: Debt to Equity Ratio Uses
Value investors know the importance of the debt for operating a business and they also know that too much debt can kill. Normally I would like to see most companies have some amount of debt as debt is a cheaper source of financing operations. Some debt on the balance sheet also leverages up the returns to the equity shareholders.
Normally I start getting worried when the debt/equity ratio goes over 1. When the D/E ratio exceeds 2, it is generally a warning sign. You will find that many capital intensive industries tend to have greater debt/equity ratios as tangible assets are financed using debt. Of course, other considerations also come into play to determine if a given debt/equity ratio is healthy and sustainable. A higher cash turning business (quicker cash conversion cycle) and cheaper cost of debt (interest rate) will allow a company to lever up more, especially if the assets that are -part of the collateral do not depreciate very quickly (long lived assets). However, if a company is adding debt to pay dividends (for example), there is no collateral and I will worry about the sustainability of this business practice regardless of the current debt/equity ratio.
The debt/equity ratio is a simple thing to calculate, but can give you a lot of powerful information. As a basic balance sheet equation, it shouldn’t be difficult to acquire the needed information to calculate it, but once you do, you’ll have a clearer picture of the financial stability and strength of a company.