When you hear the word “debt,” it probably feels like a heavy word. It’s something you want to avoid, right. You immediately start thinking of credit card bills, high interest rates, and student loan debt (especially if you’re a minority or millennial).
But when you’re running a business, debt isn’t all bad. Analysts and investors recommend that companies use debt smartly to finance their businesses and build good credit history. That's where the debt-to-equity ratio (D/E) comes in.
In your own personal capital structure (which we talk about in our free financial courses in our app), it’s not as great, but if you’re investing in the stock market, it’s something to look at. If you’re planning on starting to invest your hard-earned cash, take a seat and walk through debt-to-equity with us first. It’s something you’ll wanna know about.
Understanding Debt-to-Equity Ratio
Debt-to-equity ratio is a metric. Basically, it’s a ratio that indicates risk or leverage.
When you look at this ratio, you’re looking at how a company uses its debt. It’ll show you the proportion of equity and debt used to finance its assets. When you understand that, you can understand the risk involved with you stock you’re thinking of investing in.
How is debt-to-equity ratio calculated? It looks at both debt and equity, with debt being how much a company owes and equity referring to their assets. Typically, the ratio is calculated by looking at the actual balance sheet of the business (where they keep all the official numbers), but sometimes it’s calculated using the market values for both.
Businesses look at it to figure out how much debt they’re using to run their business. You can look at it to figure out the same, but from an investing standpoint. Expert investors recommend that, if you’re investing in any company or are thinking of doing so, it’s important to pay attention to this ratio.
Fun Fact: According to data provided by the Securities and Financial Markets Industry Association (SIFMA), American companies have never had so much debt on their books as they do now. As of the fourth quarter of 2019 and to date, non-financial companies owed about $9.6 trillion (and increasing) in outstanding debt, a figure that’s up more than 57% from the financial crisis 10 years ago. So, it’s a pretty important ratio to check out when deciding whether or not to invest.
How is the Debt-to-Equity Ratio Calculated?
Wanna break this down further? To calculate the debt-to-equity ratio, you simply take the company’s total debt and divide it by their equity (you’ll find this listed as the company’s book value; you can also calculate it by subtracting their liabilities from their assets).
Here’s the formula:
Debt-to-Equity Ratio = Total Liabilities/Shareholder’s Equity
Here’s an example. Let’s say you’re looking at investing in a small business that owes $2,800 to debtors and has $2,500 in shareholder equity (we’ve broken these numbers down quite a bit; it would usually be at least in the millions for bigger companies), the debt-to-equity ratio is 1.12:
Debt-to-Equity Ratio = $ 2,800/$2,500 = 1.12
What’s a Normal Debt-to-Equity Ratio?
An ideal debt-to-equity ratio is anything that’s close to 1. The idea is that a company’s liabilities equal the equity they have. However, it’s worth noting that debt-to-equity ratio varies from industry to industry.
For large public companies, you might find that the debt-to-equity ratio is slightly over 2, but that ratio would be unacceptable for a smaller company. Most US companies show an average ratio of about 1.5, which issimilar for other countries too.
If you’re looking as this number as part of an investing strategy, it’s best to stick to a company with a ratio of around 1 or slightly higher.
Limitations of Debt-to-Equity Ratio
When using the debt-to-equity ratio as a metric for an investing strategy, it’s important to consider the industry the company belongs to. Why? Different industries have different capital needs and growth rates.
The best real-world example we can offer is to have you think about capital-intensive industries such as auto manufacturing. They require a lot of capital to build and sell their products. This is why companies in that industry tend to have a debt-to-equity ratio over 1. Tech firms, on the other hand, require less capital to operate and tend to have ratios around 0.5.
The point is that you can’t look at debt-to-equity ratio alone when figuring out whether or not a company is worth investing in. Sure, you can use it as a benchmark. But it’s relative to other metrics and, most of all, the industry that the company is in. Here’s a list of standard debt-to-equity ratios by industry to help you get started.
The Bottom Line: What to Know About Debt-to-Equity Ratio
If a company has a high debt-to-equity ratio, it indicates that it probably can’t generate enough cash to meet its financial obligations or pay off debts. However, suppose this same company has a low debt-to-equity ratio. In that case, it may also indicate that it is not taking advantage of the higher profits that financial leverage can bring.
This is why it’s important to have a basic understanding of investing for beginners. Wealth Stack can help you with that! Our free financial courses offer you the ability to learn at your own speed. And you can learn in a way that’s easy to understand and implement.
Want to continue learning about how to invest in yourself and improve your finances? Download the app for free on the App Store or on Google Play.