How Does Debt-to-Equity Ratio Measure Financial Health?

By: Dave Roos  | 

debt to equity
Calculating debt-to-equity ratio is a great way to measure the relative financial health of a company or an individual in relation to future goals and needs. Nick Youngson/Alpha Stock Images CC BY-SA 3.0

Smart investment is a calculated risk. As an investor, you're always looking for clues about a company's overall health and risk profile. A rising stock price only means that other investors are buying shares, but it doesn't tell you if the company is positioned to keep growing and stay profitable, or if it's heading for a financial cliff.

To get a fuller picture of a company's financial health, think of yourself as a doctor. You want to check the company's "vital statistics" the same way that a physician would check a patient's blood pressure, heart rate and cholesterol levels.

For investors, one of those vital statistics is called the debt-to-equity ratio. If the debt-to-equity ratio is high, it could be a sign the company has taken on a dangerous amount of debt, or the company might just be in an industry where high debt is the price of doing business.

Similarly, if the debt-to-equity ratio is low, it could indicate a company with a healthy bottom line, or might be a sign that the people running the business are overly risk-averse and missing opportunities to grow.

To help us wrap our heads around the myriad ways of interpreting a company's debt-to-equity ratio, we spoke with Ted Snow, a certified financial planner with the Snow Financial Group and author of the "Investing QuickStart Guide."

Advertisement

The Basics: What Is the Debt-to-Equity Ratio and How Is It Calculated?

At the most basic level, the debt-to-equity ratio is a quick way of measuring how much debt a company is using to run its business. While individuals always want to reduce their debt, things are different in the business world. Usually, some amount of debt is necessary to fund growth and innovation, which translate into higher revenue down the line.

"Anytime someone uses debt, it's a leverage point, whether it's a business or an individual," says Snow. "The more debt you have, the more opportunity there is. You have your hands on more cash, which you can use to expand a business. In good times, that's all great. But in bad times, like a recession, if business dries up you might not have the money to service that debt. Now you have a problem."

Here's how the debt-to-equity ratio is calculated:

Debt-to-equity ratio = Debt (total liabilities) / Equity (total shareholder's equity)

The good news is that for public companies, all of these numbers are available in the company's quarterly earnings and financial statements.

If you're new to investing, let's define some of those terms.

In the debt category, total liabilities include all of the money that the company owes to other entities. That includes interest-bearing loans from banks and other financial institutions, as well as "accounts payable," which is money owed to vendors and suppliers.

In the equity category, "total shareholder equity" is calculated by taking a company's total assets (cash reserves, accounts receivable, inventory, physical plants and equipment, and patents) and subtracting its total liabilities above. What's left over is the equity.

Since the debt-to-equity ratio is (ahem) a ratio, there should technically be two numbers, but the figure is usually reported as just one number, the result of dividing total debt by total equity. Here's an example: ABC Corp. reports $5 million in total liabilities and $3.5 million in total shareholder's equity. The equation looks like this:

$5 million / $3.5 million = a debt-to-equity ratio of 1.4

Advertisement

What Is a 'Good' Debt-to-Income Ratio?

Speaking generally, a debt-to-income ratio is considered "good" if it's 1.5 or lower, says Snow, "and below 1 would be even better."

A debt-to-income below 1 means that a company's total assets are greater than its total debts. That means that if the economy hits a slump and sales slow down, the company isn't in immediate risk of defaulting on its loans.

Does that mean that a debt-to-income ratio above 1.5 is a sure sign of trouble? Not necessarily. It could just be a sign that a company is aggressively growing.

"There are some really fast-growth companies out there, especially in the tech sector, that do have a higher load of debt," says Snow, "but they have the growth and the sales to make that work, to fund, or at least service the debt."

Take Tesla, for example. In June 2012, on the eve of delivering its very first electric luxury sedan, the Model S, Tesla had a seemingly high debt-to-equity ratio of 6.9. But that's because it had borrowed lots of money to develop and manufacture its cars, but had yet to sell any. By September of that same year, Tesla's debt-to-income ratio was -16.7, meaning that its assets way outpaced its debt.

Advertisement

Different Sectors, Different 'Normals'

A debt-to-income ratio of 1.5 or below is the norm for most stable public companies listed in the S&P 500, but there is a lot of variability by industry.

The financial sector, in particular, boasts higher debt-to-income ratios because borrowing money and leveraging debt is their bread and butter. Investors in financial services companies shouldn't be spooked by a debt-to-equity ratio higher than 2, because it's not crazy to see successful companies with ratios between 10 and 20.

Other industries are "capital intensive" like telecommunications, mining and refining, and the airline industry. In all of those sectors, companies often need to make large capital expenditures up front to earn money later (running miles of cable, drilling wells, building planes, etc.). To do that, they need to borrow a bunch of money.

Also, pay attention to a company's debt-to-equity ratio over time, not just what it says right now. For example, Colgate-Palmolive had a debt-to-equity ratio of 17 as of June 2021. That seems pretty high, but if you look at historic data going back the past decade, you'll see that the company went through a long periods of extremely low ratios leading up to 2019, when it made a series of very expensive acquisitions. By December 2019, Colgate-Palmolive had a debt-to-equity ratio of nearly 70! So, paring down to 17 by 2021 looks like a positive trend.

Advertisement

Can a Debt-to-Equity Ratio Be Too Low?

Small, privately owned businesses tend to have lower debt-to-income ratios, because small-business owners generally want to pay off debt as quickly as possible. But if the entire point of investing is picking a stock that will grow continually over time, then it might be smart to avoid publicly traded companies with debt-to-income ratios that are consistently in negative territory.

"A business may be forgoing growth potential if they don't have some level of debt," says Snow.

If you're looking for a rule of thumb, take this tip from Investopedia: If a company is on the rise, then a high debt-to-equity ratio might be necessary for fueling growth. On the flip side, if a company is in decline, then a high debt-to-income ratio might be the weight that pulls it under.

What's important to note is that no single financial indicator can be taken on its own. Consult with a certified financial planner or investment professional to learn more about holistically analyzing a company's health and risk profile.

Advertisement

Games

Advertisement

Loading...