The ratio of debt to equity is a financial index that is used to evaluate the capital structure of a company. Specifically, this ratio measures the composition of the balance sheet of a company, which is made up on the one hand of debt and on the other hand of the capital paid by the shareholders. The relationship between debt and equity (also called financial leverage or leverage, in English) provides the financial analyst and potential investors with a quick tool to understand the impact of debt in a company, and consequently its exposure. fluctuations in interest rates and the risk of default. Knowing how to analyze the ratio of debt to equity can help you determine the health of a company to decide whether or not to invest money in it.
Steps
Step 1. Determine the debt to equity ratio of the company in question
The ratio is calculated simply by dividing the company's total debts by the capital contributions of the shareholders. These items can be found in the company's financial statements.
- Generally, only large and long-term debts are included in the ratio calculation. Short-term bonds, such as overdrafts, are often left out as they don't provide much information about the company's borrowing.
- However, some off-balance sheet obligations should also be included in the calculation, when they are large enough to affect the ratio of debt to equity.
Step 2. Make a quick assessment of the company's capital structure
Once you have determined the ratio of debt to equity for a certain company, you can get an idea of the firm's capital structure. A ratio of one, for example, indicates that the company finances its projects with an equal amount of debt and equity. A low ratio (below 0.30, roughly) is generally considered good, because the company has a low amount of debt, and is therefore less exposed to risk in terms of interest rates or credit ratings.
Step 3. Consider the specific financial needs of the industry in which the company operates
Generally, a high debt-to-equity ratio (equal to or greater than 2, for example) is worrying, as it indicates high borrowing. However, in some areas it may be appropriate. Construction companies, for example, finance their projects almost entirely through borrowing, in the form of mortgage loans. This leads to a high debt-to-equity ratio, but the company does not necessarily run a real risk of default.
Step 4. Determine the incidence of own shares in the ratio between debt and equity
When a company issues shares, the shares are shown in the balance sheet at their par value. When the company repurchases its own shares (so-called buy-back), the own shares are recorded in the financial statements at their purchase price; this can lead to a decrease in the amount of capital, increasing the ratio between debt and equity. A high ratio could therefore simply be the result of a buy-back of own shares.
Step 5. Extend your analysis with other financial indices
The ratio of debt to equity should never be used alone. For example, if a company has a high debt-to-equity ratio, you may reasonably be concerned about their ability to pay off their debts. To address this concern, you can also analyze the interest coverage rate, which is the company's operating income divided by the measure of net interest expense. A high operating income also allows a debt-ridden company to meet its obligations on a regular basis.
