There is no quick and easy way for investors to get a handle on a company's debt situation. But as a starting point, debt ratios offer a valuable method for assessing a company's fundamental health. Looked at in context and over time, debt ratios can offer valuable signals of deepening debt problems. An example of this was seen during the financial crisis of 2008/09, whereby many financial institutions overleveraged themselves with debt, and as assets fell in value, the ratio of debt within the organizations became too high to be sustainable. Recognizing those situations, in advance, can save investors a lot of money. In this article we'll examine one specific debt ratio in detail, to help you do that: the debt-to-equity ratio.

Importance of Looking at Debt
While debt ratios tell investors little about a company's growth prospects or earning performance, these ratios are vital tools for gauging balance sheet durability. If, for instance, a recession or downward cyclical phase is on the way, balance sheet strength becomes more important for investors. It can determine whether a company has a strong enough financial position to survive through a tough period.

Financial markets tend to punish overextended firms at the start of a recession. The reason is simple: debt-leveraged companies have the hard task of paying their interest obligations out of a flat or declining level of income. Those firms that are unable to pay for their debt go bankrupt. Those that struggle to pay lose credit worthiness and face further financing troubles down the road. Shrinking profits make debts that are otherwise manageable look horribly burdensome.

Calculating Debt-to-Equity
The debt-to-equity ratio offers one of the best pictures of a company's leverage. The formula is straightforward:

Debt-To-Equity = Total Liabilities / Total Shareholders\' Equity

Quite simply, the higher the figure, the higher the leverage the company employs. Notice that this ratio uses all liabilities (short-term and long-term), and all owner's equity (both invested capital and retained earnings).

Interpreting the Ratio

Let's say a company has long-term debt of $10 million in the form of a bond outstanding and equity of $10 million. The debt-to-equity ratio is 1 (10/10=1). If the same company has the bond outstanding and only $1 million in equity, then the debt-to-equity ratio is 10 (10/1=10). This company is probably in big trouble. Alternatively, if the company has the $10 million bond outstanding and $20 million in equity, giving a debt-to-equity ratio of 0.5, investors can feel a little bit more comfortable. We can interpret a debt-equity ratio of 0.5 as saying that the company is using $0.50 of liabilities in addition to each $1 of shareholders' equity in the business.

Granted, a company with no debt may be missing an opportunity to increase earnings by financing projects that will give a better return than the cost of the debt. A little debt can be good for a company's earnings. On the other hand, a high debt-to-equity ratio translates into higher risk for shareholders since creditors are always first in line for compensation should the company go bankrupt. Shareholders must wait at the back of the queue for dibs on assets.

In the big picture, the debt-equity ratio tells us that debt isn't bad as long as there is a sufficient amount of equity. When an investor buys equity it reflects positively on the company's outlook. On the other hand, it's a bad situation when a company can only raise money by issuing debt.

Comparing Companies
After determining the extent of a company's debt, the investor should next assess whether the company's debt-to-equity ratio is too high. As with any ratio, this depends on a company's industry; however, it's generally accepted that industrials should maintain a debt-to-equity ratio between 0.5 and 1.5.

Another way to gauge the strength of a company is to companies with similar credit ratings - which the big credit rating agencies, Moody's and Standard & Poor's (S&P) - provide for investors to look up. Investors can then get a better sense of whether a company is highly leveraged compared with peers and possibly a candidate for a downgrade.

A credit downgrade is no trivial matter since it raises borrowing costs. A company with the lowest of the four investment grade ratings - Baa in Moody's rating system and a BBB from S&P - can borrow at an average of 3.6 percent points over benchmark treasury. Once companies slip into junk status, they are in dire straits. As default rates on junk-rated debt is above nine percent, companies with junk status face an average interest rate that is a whopping ten percent points above Treasuries--these days, that translates into roughly 12 percent for a five-year loan.

Firms have been adding to their borrowings and thereby squeezing out greater returns for their investors. On average, debt-to-equity ratios have been on the rise over the past two decades. But shorter technology and product cycles, persistent de-regulation and fiercer global competition also keep adding risks to the business environment and to company fundamentals. Investors need to think carefully about how much of the extra debt risk they want to bear.

Here is one final warning: although the debt-to-equity ratio is a valuable number to examine, investors cannot focus only on it without any other indicators. There are a number of frequently used debt ratios that show how much a company relies on debt financing. These include the debt ratio, the current ratio, interest coverage, etc. Together they vividly show how the amount of debt leverage can vary between healthy firms with low debt levels and plenty of cash to service it and troubled companies that are heavily leveraged and cash-poor.

Related Articles
  1. Trading Strategies

    Introduction to Types of Trading: Fundamental Traders

    Learn about the different traders and explore in detail the broader approach that focuses on company-specific events.
  2. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  3. Credit & Loans

    What's a Nonperforming Loan?

    A nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days.
  4. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  5. Economics

    Understanding Cash and Cash Equivalents

    Cash and cash equivalents are items that are either physical currency or liquid investments that can be immediately converted into cash.
  6. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  7. Investing

    Factors Driving Kroger's Success

    Kroger’s focus on optimizing customer experience and cultivating its own product lines has proven to be successful strategy.
  8. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  9. Investing News

    How 'Honesty' Could Pay off for Jessica Alba

    Is it possible that Jessica Alba is one of the savviest businesswomen on the planet?
  10. Investing Basics

    3 Companies That Hate Debt Financing

    Learn how companies such as Chipotle, Bed Bath & Beyond, and Paychex are able to maintain impressive levels of growth without debt financing.
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the ...
  2. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  3. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  4. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  5. Equity

    The value of an asset less the value of all liabilities on that ...
  6. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why can additional paid in capital never have a negative balance?

    The additional paid-in capital figure on a company's balance sheet can never be negative because companies do not pay investors ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!