In this article, we’re going to talk about the debt-to-equity ratio. For starters, the debt to equity ratio is considered what we call a leverage ratio and the reason it’s considered to be a leverage ratio is that it measures the degree to which a company is financed with debt. As we know debt is a really important thing to keep track of for companies for a number of different reasons, the debt, of course, is reported on the company’s balance sheets and we know that as a firm accrues more debt there are certain things that begin to happen as a result of that the most obvious thing, of course, is the increase in interest payments associated with that debt and that can be a really big difficult thing for companies because those increased interest payments represent a fixed cost. As we know fixed costs are paid regardless of sales and so that begins to eat into the cash flow of a company and cash is something that a company absolutely wants to protect because it can certainly be used to pay for things like inventory employees and a number of other different things.
Also as a company accrues more debt it becomes inherently riskier and so banks or other financial institutions may continue to lend money to the company however they may do so at a higher rate or may require collateral or covenants and different things that might restrict the company’s operations and ability to get future funding. So although all debt isn’t necessarily bad too much of it can very much so restrict the operations of a company. For that reason, we look at ratios like the debt to equity ratio to get a better understanding of how a company is financed and also do some basic analysis to determine if a company’s debt load is potentially going to be an issue.
Let’s talk through how you actually calculate a company’s debt to equity ratio, it’s very simple you’re going to get all of this information off of the balance sheet for a company. The first thing you’re going to look for is what we call the total liabilities and total liabilities is going to include both current and long-term. So current liabilities being those debts that are going to be due in one year or less and then that, obviously long-term being everything over one year and you’re going to take that figure and you’re going to divide the total liabilities by the total equity or total stockholders equity or total owner’s equity all of those terms can be used interchangeably. Let’s do this just briefly so you kind of have an idea of how it’s going to function and then just as an aside you’re going to take the result of that and multiply it by a hundred to put it in percentage terms.
Let’s walk through a quick example so you can see how this actually works. The Earth Metal got $500,000 that we have financed through some combination of liabilities whether it be loans or bonds and we also have $250,000 that we financed through equity and we’re going to take that number and multiply it by 100. So we know that $500,000 divided by $250,000 is of course 2, multiplied by 100, and that gives us 200%. The way that you want to look at this is anything that is greater than 100% what that means is that a company is more heavily financed through debt.
Now, this isn’t necessarily a bad thing but it is something to look into, the other way you can explain this is we have twice as many liabilities as we do debt. The other way that we can quantify it or at least explain it is that: for every dollar that we have financed through equity, we financed two dollars through debt. So that is one way to just kind of communicate that to someone if you were to get a debt to equity ratio of whatever percentage let’s say it’s 150%, you can say that for every dollar that we have financed through equity we financed $1.50 through debt and so to really makes it easier to understand versus giving people a percentage and they don’t really know what to do with it.
So let’s talk about what you do afterward so let’s say we were to get a debt to equity ratio of 200% is that good or bad? Well, it really depends unfortunately, there isn’t a standard debt to equity ratio that works for every single company and that’s because companies have different business models and they operate in different industries and so the most helpful thing you can do is take a look at some of the debt to equity ratios that are within the industry that your business operates. If you’re in the retail sector for example and you’re evaluating Walmart and its operations and you would want to look at the debt to equity ratio of a company like Target or a Kmart or Sears maybe even Amazon to an extent.
Although Amazon does some non-retail business as well as their kind of core retail operations to do those things you would get a better understanding of what is considered to be a relatively standard debt to equity ratio. You’re still going to see some variability within that but you’re going to be going to get much more specific and have a better understanding of what a fair debt load might be if you just kind of take a general blanket debt to equity ratio that’s not going to apply to that company the other thing that you want to do is you want to compare the debt to equity ratio for the same company at prior points in time and so if you’re analyzing 2016 you can take a look at 2015 and 2014 and you can start to see trends is the company leaning more towards the debt which may not be a bad thing but it could be something to look into are they reducing their debt loads which can, of course, free up cash to do other things those are some of the things that you want to look at but you don’t want to just take the one statistic and then develop a number of different conclusions you want to go ahead and compare it to other companies in the same industry, as well as that same company at Prior points in time.
Debt to Equity Ratio