Debt to Equity Ratio Calculation
To calculate this number, simply divide all liabilities by the shareholder equity (liabilities/equity=d/e). Sometimes it is expressed as a percentage.
- 0 Debt / Any Equity Value = 0
- $1,000,000 Debt / $1,000,000 Equity = 1 or 100%
- $1,000,000 Debt / $2,000,000 Equity = 0.5 or 50%
- $2,000,000 Debt / $1,000,000 Equity = 2 or 200%
What This Ratio Means
This calculation quickly shows how much financial leverage the company has. You will instantly know if debt has been financed with every dollar of equity (a ratio of 1), if the company has very little debt compared to its assets (a low ratio such as 0.2), or if the company owes more than it is worth (any ratio over 1).
Statistics Canada indicates that certain industry groups have higher ratios than others. For example, real estate rental and leasing had an average ratio of 1.792 in the second quarter of 2010, while insurance carriers had 0.236. We would hardly expect a company that earns rental income off assets to have the same debt to equity ratio as company writing policies on paper.
Comparing With Its Peers
First, we should understand how much leveraged debt this company carries when compared to its peers. After determining the ratio for a specific company, we compare this with the average of its industry or sector. A ratio that appears too high might actually be below average when considering the type of business. Or a ratio acceptable in one industry might be abnormally elevated when facing a jury of its peers.
Low Debt Ratios Always Good?
If the ratio is quite low, this can give us confidence to explore other fundamental ratios such as growth. Having a company with little financing should keep the creditors at bay. But wait… is a low ratio always the best? There are some circumstances where the company could be selling themselves short by not financing.
Most investors would be nervous of a company that quickly assumed debt for a trivial cause. But what if the company had a high growth opportunity that required more cash then what was on hand? Would investors still be happy to learn that this same company neutered its large growth opportunity out of fear of assuming any debt? Probably not.
The point is that while low debt is optimal, there are times when a business should be willing to assume some financial risk, and especially so when a potentially high earning prospect appears.
Be Cautious of Highly Leveraged Companies
On the other hand, high debt can also be the downfall of a company. When interest rates are low, a company might be disposed to assuming debt in favor of growth. But what if the debt to equity ratio reaches uncomfortable limits? What will happen when interest rates rise or if the company has a drop in their credit rating?
A small change could boost interest rates which could literally bankrupt a company. Debt should only be assumed at a rate which the company can pay in all seasons, and despite a change in credit rating.
Understanding the debt to equity ratio calculation will help investors determine if a stock is a good long term choice for the portfolio.