Investors often consider a company’s debt-to-equity ratio when evaluating the stock. If the number is roughly 4, it means that for every shareholder dollar, there is $4 of debt. What’s high or low, or good or bad, depends on the sector. Financial industry companies tend to have the highest numbers, say, 20, while stable manufacturing companies are often in the low single digits. Having a number lower than 1, say, 0.45, could invite a buyout. Knowing what the ratio is and what makes a good debt-to-income ratio can help you make investment decisions. Read on for more about this useful metric.
Check out our investment calculator.
What Is a Debt-to-Equity Ratio?
Just as it sounds, a debt-to-equity ratio is a company’s debt divided by its shareholders’ equity. Translation? A company’s debt is its liabilities or the money on its books that’s in the red. Some people use both short- and long-term debt to calculate the debt-to-equity ratio while others use only the long-term debt. The stockholders’ equity represents the assets and value of the company, or money that’s in the black. That includes initial investments, money paid for stock and retained earnings that the company has on its books.
You can also calculate your own, personal debt-to-equity ratio by taking your debt and dividing it by your net worth. If you’re debt-free, your ratio will be 0. The higher your ratio, the more precarious your financial situation is. If you lost your only income source, how would you meet your debt obligations (i.e. pay your credit card bill, mortgage or car payments)?
Check out our asset allocation calculator.
How to Use the Debt-to-Equity Ratio
So how do you use the debt-to-income ratio in real life? Analysts and investors generally use the debt-to-income ratio of a company to evaluate how much risk the company has taken on – and how risky it would be to invest in the company.
As an investor, you can always buy index funds and engage in passive investing. But if you want to try your hand at active or retail investing, you’ll probably engage in some research before buying company stocks (we hope). Looking at companies’ debt-to-equity ratios should be part of that research.
What Is a Good Debt-to-Equity Ratio?
Just like an individual whose debt far outweighs his or her assets, a company with a high debt-to-equity ratio is in a precarious state. A high debt-to-equity ratio indicates that a company is primarily financed through debt. That can be fine, of course, and it’s usually the case for companies in the financial industry. But a high number indicates that the company is a higher risk. That’s why a high debt-to-equity ratio may be a red flag for investors. In fact, it may also turn off lenders, partners and suppliers.
On the other hand, a low debt-to-equity ratio means that a company’s liabilities are low compared to its assets. That’s often the case for stable. long-running manufacturing companies. You would think a low number is generally good, but it does invite other companies on the lookout for acquisitions. It also signals that the company is not aggressively growing its business.
Creditors also use the metric. Sometimes, they’ll impose limits on a company’s debt-to-equity ratio to keep a company from becoming over-leveraged. A creditor could stipulate in a debt covenant that the company that’s borrowing money must not exceed a certain debt-to-equity ratio. That would keep the company from taking on excessive debt and damaging the position of the original creditors. Those who invest in and lend money to companies worry that if the company fails, they won’t get their money back after the dust settles.
Related Article: The Best Ways to Invest $10,000
If you’re assessing potential investment opportunities, it’s worth taking a look at a company’s debt-to-equity ratio. It’s not the only piece of research worth doing, but it does provide important information about how much risk and leverage the company has taken on. To know whether it’s high or low, you should compare it to the debt-to-equity ratio of other companies in the same industry. You can also use the metric to assess financial risk in your own household.
Photo credit: ©iStock.com/poba, ©iStock.com/Hiob, ©iStock.com/FangXiaNuo
Tips for New Investors
- Don’t go it alone. If you want to give stock picking a try, a financial advisor can help. Head over to SmartAsset’s SmartAdvisor matching tool to get paired with a financial professional who specializes in tactical investing.
- Start with exchange-traded funds (ETFS). These baskets of different stocks carry less risk than individual stocks. But they trade like a stock, so you can follow share prices and pull the trigger, to buy or sell, when the price is right.