The debt-equity ratio is measured by dividing an organisation’s complete debt by its stakeholder equity. The balance sheet section of the organisations financial statement should readily provide this. It is a measure of how an organisation is funding its day to day activities, using debt or its own money.
A bit of a deep dive is usually needed to understand the true D/E ratio, as it can be skewed by factors such as intangible assets, pension adjustments, retained profits or losses etc. In some cases, analysts modify this parameter to be more insightful, it also makes it easier to compare between stocks.
What Can You Learn From D/E Ratio
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Given that it measures debt relative to the value of assets, it is often used to understand the level to which an organisation takes on debt as a means of leveraging assets. A high D/E ratio could mean that the company is taking big risks and is being aggressive in funding its growth with debt. This is a high risk vs high reward scenario – the organisation could earn more with the borrowed money or it could lose (part of) the borrowed money. It is important to comprehend the situation and the company before investing further. Also, long term assets and debts have a larger impact on the D/E ratio than short term debts and assets, this is because usually, the sum of long term debts and assets is larger. Other ratios need to be used for assessing the short term financial situation.
Modifications to D/E Ratio
A common modification to the D/E Ratio is to convert it to a long-term D/E Ratio, which helps focus on more important risks. Short-term liability is indeed part of the complete position of an organisation, but it will be cleared in a year or less. Which makes it less risky. Imagine an organisation with $1 million in short-term liabilities and $500,000 in long-term liabilities. Compare that to an organisation with $500,000 in short-term liabilities and $1 million in long-term liabilities. Both have $1.5 million in equity, meaning both have a D/E ratio of 1.00. The risk of both organisations may seem identical, but in reality, the second organisation bears a bigger risk. This is because borrowing in a short term is less expensive than in a long term. Long term debt is more vulnerable to changes in interest rates – if the interest rates go up, operations will be more expensive. If the interest rates go down, refinancing costs come into the picture. This also drives up expenses.
This can be seen in an example in eToro. Navigate to a stock of your choice, in this case, Apple (AAPL), and go to the Stats tab. Once there, scroll down to the Financial Summary section. Once there, you can navigate to the Balance Sheet view.
In this view, you can see both, the long term debt to equity and total debt to equity. Here it is expressed as a percentage.
Limitations of D/E Ratio
It is extremely important to take into account the industry in which the organisation exists as different industries have different financial requirements and growth. A high D/E ratio may be the norm in one industry, whereas, a comparatively low ratio in another. An example, capital-intensive industries tend to have a higher D/E ratio, often over 1. Whereas technology companies could have lower ratios, often around 0.5. Utility stocks are a good example of this situation as they have high capital expenditure (which incurs a debt, which is cheap), slow growth but are able to maintain a steady income stream.
What D/E Ratio should you look for?
The answer, as always, it depends. On the nature of the industry. A ratio below 1 is considered comparatively safe and ratios higher than 2 could be risky.
I see a negative D/E Ratio, what does that mean?
This shows that an organisation has more liabilities than assets and is a very risky sign. Often, this could be a sign of upcoming bankruptcy.
If you have not already, do read about other important metrics of stock picking in our series. For the rest, feel free to practice using the eToro Demo Practice Account.
This Article is Part of A Total guidance list on How to pick individual stocks, make sure you go by the article one by one to get a bigger understanding of the total picture. 😉
- How to Pick an individual stock Part 1 - The Strategy
- How to Pick an individual stock Part 2 - 5 metrics to look at when stock picking
- How to Pick an individual stock Part 3 - P/E Ratio (Price-Earnings ratio)
- How to Pick an individual stock Part 4 - Earnings Per Share
- How to Pick an individual stock Part 5 - Dividend Yield
- How to Pick an individual stock Part 6- Company History And Strength
- How to Pick an individual stock Part 7- Debt-Equity Ratio
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