Investors looking to buy a stock typically focus on a company’s share price, earnings and growth potential. But they often overlook an equally telling metric—how much debt the company carries. Understanding the amount of money a business has borrowed—whether with loans from a financial institution or money raised from issuing bonds—is a quick way to assess a company’s financial health and offers a signal about whether its stock is worth further investigation.
Important: Going into debt can be good for a business because it allows the company to expand at a faster rate and increase its revenue and profits. But it also carries risk—high debt can cripple a business. If the economy hits hard times and the company can’t make its interest payments, the debt escalates…the company faces a cash crunch…and skeptical lenders may be reluctant to provide more capital, increasing the risk for bankruptcy.
Investors can determine how risky a company’s debt is by using a simple formula called debt-to-equity ratio, also known as a debt-to-assets ratio or debt ratio. This metric measures how much debt is being used to finance the company versus the company’s overall net worth (also known as shareholder equity). You can find the debt-to-equity ratio for any company at FullRatio.com. Type in the ticker symbol. It will bring up a page that features “Key Stats.” Under “Liquidity” you will find a metric labeled “debt to equity.”
What Is a Good Debt-to-Equity Ratio?
A debt-to-equity ratio under 1.0 is considered excellent…1.0 to 2.0 is within normal range…and over 2.0 could be a cause for concern.
Conservative investors prefer a lower debt-to-equity ratio because it indicates a financially stable company with minimal reliance on borrowed funds. Example: Microsoft’s debt-to-equity ratio was recently 0.17.
A higher ratio indicates a company has a riskier balance sheet because it finances a significant portion of its operations through borrowed money. Example: Ford Motor Company’s debt-to-equity ratio was recently about 3.42.
Things to keep in mind when assessing debt-to equity ratio…
Debt-to-equity ratio tends to be naturally higher in some industries without indicating financial distress
Examples: Banks often have high debt-to-equity ratios because it is standard practice for them to borrow large amounts of money, then invest it for higher returns. The telecommunications industry requires significant levels of debt to fund its large infrastructure projects. Conversely, software firms tend to have low debt-to-equity ratios since less expensive infrastructure and stronger cash flows allow them to operate with less reliance on debt.
What really matters for an investor is how a company’s debt-to-equity ratio compares to those of its industry peers
If a company’s debt-to-equity ratio is much higher than those of its peers, the company may be overleveraged and more vulnerable to economic downturns and interest rate fluctuations. If it’s much lower, management may not be remaining competitive enough or taking advantage of borrowing to generate better returns for shareholders.
