Welcome to the new Tradimo learning platform. If you come from the previous version of Tradimo, you need to register again. Apologies for the inconvenience

Welcome to Tradimo! Here is our special offer for new users: Buy your first course now and get 10% off! 

0:00/5:16

Debt-to-equity ratio

A company's debt to equity ratio shows you what proportion of debt or equity a company is using to finance its assets. The debt to equity ratio is calculated by dividing its total debt by its total shareholder equity:

Debt/equity ratio = Total debt/shareholder equity

A high debt to equity ratio shows that the company has a relatively heavy debt load.

This is usually a bad sign for shares investors because the cost of servicing high debt levels can pressure a company's earnings and make them more volatile. It can also do the same to its share price.

Different kinds of companies have different debt to equity ratios. For example, a ratio of 2 is considered healthy for capital-intensive industries like car makers, while software makers could have a ratio as low as 0.5.

 

Debt is not necessarily a bad sign

Heavy debt is not always a danger sign though, especially for capital-intensive industries like car manufacturing, which typically have a debt to equity ratio higher than 2 and are still considered healthy.

In contrast, software companies, which do not need lots of expensive machinery to produce their goods, tend to have a debt to equity ratio as low as 0.5.

Also, if money that has been borrowed is invested prudently it can boost a company's future earnings.

The cost of borrowing is a significant factor

What you the, potential shareholder, need to research is how much that debt is costing the company in interest.

If the earnings growth that the borrowed money generates is higher than the cost of borrowing it, a high debt to equity ratio can be a positive for the company's financial health and its share price.

For example, if a company has total debt of £2 million and total assets of £2 million, this gives it a debt to equity ratio of 1. If it then takes out a £4 million loan to buy a new production facility, its debt to equity ratio will rise to an unhealthy-looking 3.

If however, the new factory generates a 6% return on assets and the interest on the loan is 4%, the relatively high debt to equity ratio is positive for the company and could boost its share price.

If interest rates on the debt later rise to 7%, the company is now paying more for its debt than the 6% return on assets the factory is generating. This could in the long term lead to bankruptcy, and wipe out the value of the company's shares.

Shares investors should therefore keep an eye on national interest rates and on a company's credit rating.

If interest rates are rising or a company's credit rating falls, it will have to pay more for its debt. This will help you gauge how much of a potential problem a high debt to equity ratio might become.

If money that a company has borrowed is generating higher returns than it cost to borrow it, a high debt to equity ratio is not necessarily a bad thing. Keep an eye on interest rates and the company’s credit rating to see how its borrowing costs might change.

 

Summary

So far you have learned that...

  • ... a company's debt to equity ratio calculation shows you what proportion of debt or equity a company is using to finance its assets.
  • ... different kinds of companies have different debt to equity ratios. For example, a ratio of 2 is considered healthy for capital-intensive industries like car makers, while software makers could have a ratio as low as 0.5.
  • ... if the earnings growth that the borrowed money generates is higher than the cost of borrowing it, a high debt to equity ratio can be a positive for the company's financial health and its share price.
  • ... if interest rates are rising or a company's credit rating falls, it will have to pay more for its debt.