Making Use of the Debt to Equity Ratio

A company's debt to equity ratio is a measure of how aggressive it has been in leveraging its assets for growth. As the name implies, the ratio is a simple measure of debt over equity. If the debt to equity ratio for a company is in the whole numbers rather than a fraction, the company may be carrying too much debt in comparison to its actual net worth.

Factoring in Investor Funds

Debt does not include funds provided from investors since these funds do not need to be repaid. In fact, having many investors will  actually add to the equity a company has and therefore benefit the measure of debt to equity. For example, if a company has $100 in debt in comparison to $300 equity, the debt to equity ratio is .33, or 30 percent, which is fair. However, if 10 new investors come in each offering $10 in exchange for equity, the company may offer more shares. The result would be an additional $100 of equity for the business. This would mean the debt to equity ratio went down to .25, or 25 percent, which is even better than before.

Using Debt to Equity in Earnings Yield

The earnings yield of a stock is the value of its earnings per share over the past twelve months divided by the total assets of the company. In this model, which is often used to determine if a stock is properly valued, both debt and equity count toward total assets. If you were to only factor in earnings yield when deciding to buy a stock, you may be missing a key analysis of the spread of the total assets held by the company. The total assets may have been falsely inflated if the company had a very large amount of debt. Factoring in the debt to equity ratio when considering earnings yield can give you a more complete picture.

Debt to Equity in Future Financing

Another factor to consider when a company has a high debt to equity ratio is that the company may not be able to get more financing in the future. If the business would like to expand to capitalize on new profits, it would find a challenging time gaining bank financing. Its only option may be to increase the number of shares it is offering, which would reduce the value of the individual shares you are holding.

Debt to Equity in Bankruptcy Risk

Some industries can carry a higher debt to equity ratio than others without risking bankruptcy. A utilities company, for example, does not expect large swings in its profit. Even in a market downturn, the company would continue to profit. This company would not be at risk of falling into bankruptcy if an unforeseen change occurred in the economy. An automobile manufacturer, on the other hand, operates in a very fickle market. If a recession occurs, this individual company is at a high risk of bankruptcy if it has a high debt to equity ratio. Therefore, it is far better for this type of company to maintain a low ratio.

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