There are may elements that investors use to help them decide which stocks to add to their portfolio to ensure the greatest return on investment. The debt to equity ratio of a company is one such element.
The debt to equity ratio is a measurement of how much leverage the company has, and is an indicator of their solvency. Solvency is how much a company’s total assets exceed total liabilities. When this number is positive, a company is performing well, and when it is negative…not so good.
Who uses it?
A variety of financial institutions will use the debt to equity ratio to determine risk and lending rates. A high debt to equity ratio will force banks and creditors to amend contracts requiring a significant repayment against the outstanding debt. The current financial problems faced by the US government is an example of creditors and lenders working with an entity with a high debt to equity ratio.
On the reverse, a low ratio will open up opportunities for investment that are not otherwise available, in the form of favoured lending rates and foreign investment.
And of course, investors will use a debt to equity ratio to help determine a stocks value.
How is it calculated?
A company’s debt to equity ratio is the ratio left after the company’s total liability is divided by the shareholders equity, which is total assets minus total liabilities. Liabilities are all of the loans, mortgages, and accounts payable the company has. So in layman’s terms, the debt to equity ratio is the amount owed divided by the amount owned. A high number is not good. A ratio of two or higher in most industries is a bad sign.
How to use it to invest
Overall, the debt to equity ratio can provide a good barometer of a companies financial health. A high ratio can be a warning sign that a company is to aggressive in itss growth and needs to dial back the spending, while a very low debt to equity ratio could indicate a stagnant company.Each sign requires more research on the investors part.
One thing to remember is that though the debt to equity reatio may seem high, you need to compare it to other companies in the industry, rather than an average across industries. A debt to equity ratio of 3 or 4 may seem high for a car company, but some of the largest, like Ford, carry double digit debt to equity ratios.
It’s a very powerful tool that provides a snapshot of a company’s health and a great addition to any knowledgeable investor’s arsenal.