Debt-to-equity ratio is one of the key figures used to measure a company’s financial position. The key figure compares the size of a company’s liabilities with the company’s own assets, equity. It can be used by you as an investor to determine how big a risk an investment in the company is.
The debt-to-equity ratio is a key figure
The debt-to-equity ratio is a measure that belongs to financial key figures, which is used for valuation and control of a company’s financial position.
The debt-to-equity ratio is a measure of capital strength and is used to see the relationship between liabilities and equity, or more precisely adjusted debt and adjusted equity.
The debt-to-equity ratio is strongly related to the equity-to-assets ratio, ie the proportion of a company’s assets that is financed with equity.
This means that a high debt-to-equity ratio means that the company has a low equity-to-assets ratio.
How is the debt-to-equity ratio calculated?
The formula for the debt-to-equity ratio can vary slightly depending on what the company wants to show and is often described as S / E, liabilities divided by equity.
However, the basic formula is: Debt-to-equity ratio = Adjusted liabilities ÷ Adjusted equity
Below is how the values in the formula are calculated.
Calculation of adjusted debt
Adjusted liability = Liabilities + Tax on untaxed reserves
Calculation of adjusted equity
Adjusted equity = Equity + ((1 – corporation tax) x Untaxed reserves)
Calculation of debt-to-equity ratio
The developed formula for the debt-to-equity ratio then looks as follows:
Debt-to-equity ratio = (Liabilities + Tax on untaxed reserves) ÷ (Equity + ((1 – corporation tax) x Untaxed reserves))
If the debt-to-equity ratio exceeds 1, this means that the liabilities are greater than equity.
To interpret the key figure in stock analysis
It is important to know that in many industries there is a great need to borrow money continuously to be able to run the business.
Examples of such industries are e.g. the manufacturing industry where it is more common with a higher debt-to-equity ratio than in, for example, consulting industries.
Sometimes it simply takes a lot of capital to invest in machinery and technology that then slowly pays off.
With that said, it is still the case that a company is generally more sensitive to worse times if the debt-to-equity ratio is high.
Regardless of how things go for the economy and the company, the company must always pay its debts.
There is always a limit to how long a company can hold out in bad times and if the debts are high, this time decreases. At the same time, a company can manage its debts if the income is good.
If the company has stable income that continues to grow continuously, the company is also able to pay off its debts.
The big risk is if the company has both high debts and bad income, then an investment in that company is a big risk.
If you use this key figure to analyze a company’s shares in fundamental analysis, it is primarily in comparison with other companies in the industry that you should use it.
Look at whether the company has stronger or weaker financial strength than its competitors. Also use other key figures to weigh which company you want to invest in.
What is a good or bad debt-to-equity ratio?
Whether a debt-to-equity ratio is good or bad is relative, as it is a comparison between a specific company and other companies in the same industry.
However, there are some basic guidelines that can be used to identify a desirable or undesirable debt / equity ratio:
- A high debt / equity ratio is somewhere above 50%
- A low debt / equity ratio is somewhere below 25%
- An optimal debt / equity ratio is somewhere between 25% and 50%
Debt-to-equity ratio applies to both private households and companies
The debt-to-equity ratio is not only used to see how large a company’s debt is in relation to equity.
It can also be used to see how things are in private households, where the measure instead refers to the ratio between debt and income per year.
This reduces the debt-to-equity ratio
The debt-to-equity ratio is a key figure that can be helpful in assessing a company’s financial position. A company can reduce its debt-to-equity ratio in two ways; either by reducing the company’s debts or by increasing equity.
Companies often strive to have as low a debt-to-equity ratio as possible, as this means lower financial risks.
Having a high debt-to-equity ratio can still mean that the company is profitable and doing well, especially when you are in an expansion phase and receive stable and recurring income.
The formula for the debt-to-equity ratio looks like this; liabilities / equity = debt-to-equity ratio.
If a company has $500,000 in debt and equity of $350,000, the calculation looks like this: 500/350 = 1.42.
When the figure is higher than 1, it means that the liabilities exceed the equity.
Link between debt-to-equity ratio and equity-to-assets ratio
Before I end this article, I want to highlight the link between debt-to-equity ratio and equity-to-assets ratio. Both key figures use Equity when they are calculated and both take into account the company’s liabilities.
If a company has a high debt-to-equity ratio, it has a low equity-to-assets ratio and vice versa. Equity ratio is stated as a percentage and debt-to-equity ratio with a number (ratio).
Since both key figures describe the company’s financial position or strength in connection with its liabilities, can you consider whether you need to use both key figures?
Personally, I think the important thing is to create an image of the debts with the help of one of the key figures.
Then compare that key figure with other companies in the industry and how much financial strength you think the company has if worse times come.