The Debt-to-Equity Ratio

As an individual investor looking to purchase a stock, it’s only natural that you would want to understand a company’s key financial metrics before you buy. Solvency ratios help investors to understand different elements and activities associated with debt. Realizing how a company handles its long-term debts and commitments is crucial before adding its stock to your portfolio.

This article will explore how to calculate debt-to-equity ratios, the benefits and limitations of using this common financial measurement and what it can tell investors.

What Is Debt-to-Equity Ratio?

The debt-to-equity ratio measures leverage, reflecting how a company uses debt to amplify its purchasing power. The ratio compares long-term debt directly to shareholder’s equity, which is the company’s net worth after subtracting total liabilities from total assets. This ratio is a measure of financial risk by identifying the relationship of debt to ownership interest in the firm’s financial structure.

If you’re still wondering, what the debt-to-equity ratio is, think of it like this: In a way, it helps investors measure how much debt the company uses to fund its overall management and operations. This ratio compares every dollar of equity the company holds to how much current liabilities or debt they have. Having debt as a company isn’t a bad thing, as long as it can effectively use it to continue to grow and thrive as an organization.

How to Calculate the Debt-to-Equity Ratio

As an investor, understanding how to calculate the debt-to-equity ratio is essential before investing your hard-earned money. The calculation is relatively simple:

Long-Term Debt-to-Equity Ratio = (Long-term debt ÷ shareholder’s equity)

Long-term debt refers to debt that is due in more than a year and is separate from short-term debt, which is due within the next year. These figures are broken out on a company’s balance sheet. Both long- and short-term debt are part of a company’s overall liabilities. Total shareholder’s equity is also recorded on the balance sheet. This is a company’s book value and is the difference between its total assets and total liabilities.

What Is a “Good” Debt-to-Equity Ratio?

As an investor, you want to know what a good debt-to-equity ratio is and what constitutes a bad debt-to-equity ratio. When it comes to solvency ratios, this depends heavily on the company’s specific industry.

However, a lower number generally means less risk because more debt means greater interest expense and more principal that the company must repay. If a company cannot meet its debt obligations, it could go bankrupt, leaving its stock investors with nothing. A lower number also means a company is less reliant on debt than equity, allowing it to manage its outstanding liabilities more easily and efficiently.

Acceptable numbers will vary across industries and companies. Therefore, it is essential to do your own research and utilize multiple metrics and ratios to determine if a company can effectively handle its debt or not.

What Does the Long-Term-Debt-to-Equity Ratio Tell Investors?

It’s important to understand that the debt-to-equity ratio typically refers to long-term liabilities and is often called the long-term debt-to-equity ratio. Investors can use long-term debt-to-equity ratio to evaluate how much leverage a company is using compared to the money it’s receiving from shareholders (equity).

The long-term debt-to-equity ratio is similar to the debt-to-assets ratio; however, the former typically eliminates short-term or operational liabilities that companies use to fund day-to-day management and operations. As a result, some analysts and investors believe this is a more accurate reading of a company’s financial position. In addition, it does not count items such as accounts payable in the calculation of long-term debt.

Additionally, investors can utilize the long-term debt-to-equity ratio to solely focus on the long-term liabilities of companies at a specific point in time because of the risks associated with long-term debts versus those of short-term debts and accounts payable.

Analyzing the long-term debt-to-equity ratio can help the investor decide whether the security fits within their risk tolerance constraints. AAII members can join the online PRISM Academy to learn how to calculate their risk tolerance to determine potential constraints they may face when planning for their investment goals.

Are There Limitations to Using the Debt-to-Equity Formula?

As with most financial metrics and ratios, there are limitations to solely using the debt-to-equity formula. These include:

• Difficulty comparing companies across different industries where acceptable debt levels will vary
• Multiple ways to calculate the debt-to-equity ratio of a company, so it’s essential to understand the underlying calculation when evaluating a company

As we continue to mention, all financial metrics, including the debt-to-equity ratio, need to be cross-referenced and used alongside other solvency ratios to best determine the company’s ability to handle long-term liabilities.

Where Do You Find the Debt-to-Equity Ratio?

You can find the total debts, total liabilities and shareholder’s equity on the company’s balance sheet. Unlike the income statement, which details a firm’s earnings and expenses over a period of time, the balance sheet lists all of a company’s assets and liabilities at a single point in time. The balance sheet provides a snapshot of a firm at the end of a fiscal quarter or year.

There are three major sections of the balance sheet—assets, liabilities and shareholder’s equity. These are the areas you will want to delve into for the components of the debt-to-equity ratio so that you can calculate it on your own.

How to Use the Debt-to-Equity Ratio to Invest

Knowing a company’s debt level and how it handles current liabilities can help investors more fully understand how it can meet its future obligations to stay in business. Therefore, it is critical to know how to calculate solvency ratios such as the debt-to-equity ratio before investing in any security.

When used correctly, debt can allow a company to earn a higher level of profits for a given level of owner’s equity. However, a company must pay interest on debt, whether it’s profitable or not. Too much debt may force a company into bankruptcy if cash flow dries up.

As an individual investor, you need to have the right tools and resources to purchase and sell securities confidently. With A+ Investor or our AAII Platinum bundle, you can have countless rankings, screens, commentary and grades to compare stocks or funds with ease.

Start analyzing your stocks’ solvency ratios like the debt-to-equity ratio to choose the suitable investments for