Equity refers to the funds contributed by the stockholders, plus the company’s earnings. [3] X Research source The balance sheet should include a figure labeled as total equity. When determining debt, include interest-bearing, long term debt such as notes payable and bonds. Be sure to include the current amount of long-term debt. You’ll find this in the current liabilities section of the balance sheet. [4] X Research source Analysts often leave out current liabilities, such as accounts payable and accrued liabilities. [5] X Research source These items provide little information about how a company is leveraged. This is because they do not reflect long-term commitments, but only the day-to-day operations of the business.
You should include certain off-balance sheet liabilities when calculating debt. Operating leases and unfunded pensions are two common off-balance sheet liabilities. These expenditures are often large enough to include in the debt to equity ratio. [7] X Research source Other debt to look out for may come from joint ventures or research and development partnerships. Scan through the notes to the financial statements and look for off-balance sheet liabilities. Include those greater than 10% of the total of interest bearing debt.
For example, suppose a company has $300,000 of long-term interest bearing debt. The company also has $1,000,000 of total equity. This company would have a debt to equity ratio of 0. 3 (300,000 / 1,000,000), meaning that total debt is 30% of total equity.
A ratio of 0. 3 or lower is considered healthy by many analysts. [9] X Research source In recent years though, others have concluded that too little leverage is just as bad as too much leverage. Too little leverage can suggest a conservative management unwilling to take risk. A ratio of 1. 0 means that the company funds its projects with an even mix of debt and equity. [10] X Research source A ratio greater than 2. 0 means that the company borrows a lot to finance operations. It means that creditors have twice as much money in the company as equity holders. [11] X Research source Lower ratios mean that the company has less debt, and this reduces risk. [12] X Research source A company with less debt will also have less exposure to interest rate increases and changes in credit conditions. Some companies will choose debt financing despite the increased risk. Debt financing allows a company to gain access to capital without diluting ownership. It may sometimes also result in higher earnings. [13] X Research source If a company with lots of debt becomes profitable, a small number of owners may make a lot of money.
For example, construction firms use construction loans to finance most of their projects. Although this leads to a high debt to equity ratio, the firm is not at risk of insolvency. The owners of each construction project are essentially paying to service the debt themselves. Finance companies may also have high debt to equity ratios because they borrow money at low rates and lend at higher rates. Another example would be capital-intensive industries like manufacturing. These companies often borrow money to buy raw materials for manufacturing. [15] X Research source Industries which are not capital intensive can have a lower debt to equity ratio. Examples would include software providers and professional service firms. To assess whether a company’s debt-to-equity ratio is within an appropriate range, it is a good idea to compare it to other companies in the same industry, and/or to compare its current debt to equity ratio to that of past periods.
Treasury stock purchases reduce shareholder equity and consequently increase the debt-to-equity ratio. [17] X Research source But, the overall impact on shareholders may be beneficial. This is because the remaining shareholders receive a larger portion of the net income and dividends with no increase in the debt load. [18] X Research source Financial leverage is increased by treasury stock purchases. At the same time, operating leverage (the ratio of fixed to variable costs) remains unchanged. In other words, the cost of production, pricing, and profit margins are not affected.
The debt-service coverage ratio divides the company’s operating income by its debt service payments. The larger the result, the more likely it is that the company will have enough income available to service its debt. [20] X Research source A ratio of 1. 5 or higher is the bare minimum in most industries. [21] X Research source A low debt-service coverage ratio combined with a high debt to equity ratio should concern any investor. A high operating income may allow even a debt-burdened company to meets its obligations.
