Many companies borrow money in order to fuel growth. When done intelligently this can greatly increase the business prospects for the company. Just as it makes sense for many individuals to take out a mortgage and use borrowed money to buy a house (rather than having to pay the price of the house in cash), it often makes sense for a company to borrow money to expand its business and pay back the loan via increased sales and profits, rather than paying directly out of the company’s cash account upfront.
The key is to maintain a level of debt that is not excessive given the size of the company itself and to use the borrowed money for the appropriate business expenditures. Traders often use the Debt to Equity ratio (D/E) to assess the relationship between a company’s debt and its shareholder equity.
Components of the debt to equity ratio
The “debt to equity” ratio measures a company's financial leverage and is calculated by dividing its total liabilities by the stockholders' equity. Stockholder’s equity is simply the sum of a company’s assets minus the sum of its liabilities. This ratio indicates what proportion of equity and debt the company is using to finance its assets. For example if a company has $20 million in debt and $100 million in equity, the debt to equity ratio is 20% ($20 million / $100 million).
A D/E of 1.0, indicates that the company funds its projects with an even mix of debt and equity. A low ratio (below about 0.30) is generally considered good, because the company has a low amount of debt and is exposed to less risk in terms of interest rate increases or credit rating. In sum, a lower D/E means that a company is using less leverage and has a stronger equity position.
A higher D/E means that a company is using more leverage. All other things being equal, a company with a lower D/E than another company has less inherent risk. As long as a company can pay its interest and debts there is technically nothing wrong with a high D/E. In fact in many cases, for a booming business that can easily meet its obligations, a higher D/E can help to fuel significant business growth that could not be achieved simply using existing company assets.
What traders look out for
As long as business is strong and the company takes in enough revenue to service its debt, a high D/E is usually not concerning. But if business turns down and/or revenues decline, the company must still meet its financial obligations. This can result in a rapid decline in profitability, or in the worst case, a company unable to pay its debts. Either scenario will typically result in a sharply lower price for the company’s stock.
Generally, a high D/E of say 2.0 or more may be worrisome, as it indicates a precarious amount of leverage, however, D/E ratios can vary greatly by sector. Utilities and industrials companies often have the highest D/E ratios, while information technology and consumer discretionary firms often have the lowest. Seeing a utility with a D/E of 2.0 would be concerning, whereas an info tech firm’s threshold might be much lower.
There can be exceptions however, to the “high D/E may be worrisome” guideline. In some cases there may not be a reason to worry about a high D/E ratio. For some industries such as construction, a high level of debt is common. Construction firms fund their projects almost entirely with debt in the form of construction loans. This leads to a high debt to equity ratio, but generally these firms are in no real risk of insolvency.
Also, a high D/E may occasionally be the result of stock buybacks by the company. When a company issues stock, shares are usually held on the balance sheet at par value (often only $0.01 per share). When the firm buys back stock, the treasury stock is recorded at the purchase price which results in a large subtraction from shareholder's equity, which in turn increases the D/E. But in this case the potentially worrisome D/E is simply the result of stock buybacks.
Another thing investors look out for is the appropriate use of borrowed funds for companies with a high D/E. As an example, a company that has a higher D/E as it takes on debt in order to build more manufacturing facilities in order to keep up with increasing demand would likely be considered an attractive stock. On the other hand, a company that increases its D/E by borrowing in order to finance a high dividend that it can no longer support with normal operations or a company that needs to borrow in order to maintain day to day operations would be worrisome.
Traders trust that the management of a company will act wisely and do what is in the best interest of the company and its shareholders. As such, traders typically do not spend a great deal of time worrying about whether the company’s D/E is allowing the company to maximize its profitability without assuming too much financial risk. But in the course of any company doing business, mistakes can be made and unforeseen circumstances may arise.
Analyzing the D/E for a given company offers a trader a simple way to screen for certain risk factors and to identify when a company may have taken on more debt than it can handle. Companies with low a D/E’s not only have less financial risk but also more room to work with if it wants to borrow to finance a new project. A firm with a high D/E that creates an exciting new product might have more difficulty getting the financing they may need in order to effectively capitalize on their opportunity.