Use debt to equity ratios to evaluate companies like an advanced investor. Here's how to use it and the pros and cons you should know.
The debt to equity ratio measures the leverage of a company by comparing the book value of its debts to the value of the shareholders' equity. In other words, the ratio determines how much debt a company needs to operate.
The calculation of this ratio is very simple and can be understood simply by its title. To determine a company’s debt to equity ratio, you simply divide the total debt by the total amount of equity or the total value of assets. Each of these figures is found on the company’s balance sheet.
To understand this concept, let’s take a look at an example.
Two companies, Shoes 4 You and Lace Place, have emerged as potentially enticing competitors in the shoe industry.
You, a potential investor, want to examine how each company has operated thus far and determine which would be the more reliable investment using debt to equity ratios. To compute this metric, you discover that the formula for D/E ratios is as follows: Debt-To-Equity Ratio = Total Liabilities/Total Equity
Now that you know the formula for calculating the ratio you check each company’s balance sheet (financial statements are available for all publicly traded companies). You find that Shoes 4 You has $55,000 in debt and $12,500 in total equity, while Lace Place has $33,000 in debt and $11,250 in total equity. Therefore, Shoes 4 You has higher debt but also has higher value in its company's equity. Lace Place has lower debt but also a lower value of total equity.
After dividing each debt figure by the corresponding equity for that company, you conclude that Shoes 4 You’s debt to equity ratio is 4.4 and Lace Place’s is 2.93.
The debt to equity ratio signifies the amount of financial leverage a company has, or how much debt they are willing to accumulate to operate.
Back to our example...
Since Shoes 4 You has a higher ratio of debt to equity than Lace Place, you can surmise that Lace Place uses less debt to operate its business. However, you are still not sure if 2.93 is a good ratio, so you do some research.
Now, debt to equity ratios will usually fluctuate according to the market, but generally speaking, a good ratio is lower than 1 and implies a safe investment. The ratio is considered too high if it is above 2. Therefore, even though Lace Place reports a lower debt to equity ratio, it is still relatively high and you decide not to invest.
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