When considering purchasing shares in a publicly traded company, it’s important to look at specific areas of their financial statements.
Specifically, the 2 places to consider are what kind of debt the company carries, and what kind of assets or equity the company has on hand. Looking at debt and equity can help paint a numeric picture of where the company is heading and whether or not an economic downturn will sink their ship.
The good news is that there’s a simple calculation to do this – and even inexperienced investors can find the information and figure it out. It’s called the debt-to-equity ratio.
This ratio can give you a snap-shot of the company’s financial health and maybe even an indication to where the stock price is headed in the future.
What is a debt-to-equity ratio?
The debt-to-equity ratio measures how leveraged a company is and whether they’re financing their operations through debt and by how much.
A higher debt-to-equity ratio indicates a company or stock that’s potentially a higher risk to shareholders. You typically don’t want to see this number go over 2, but you don’t want it to go under 0 either.
A debt-to-equity ratio above 2 usually indicates the company has too much liability compared to their assets. And if the ratio is negative, that likely indicates they don’t currently don’t have any equity at all and may even be close to bankruptcy.
Ultimately, it’s a best guess at how well a company can weather an economic downturn when the next one takes place. The idea is that calculating the debt-to-equity ratio is just another handy tool in your financial toolbox to make sound decisions on where you invest your money.
Debt-to-equity ratio for your personal finances
And debt-to-equity ratios aren’t just for businesses – they can actually apply to your personal finances as well.
In fact, a similar formula is used for lenders to calculate whether you’re a good candidate to lend money through a personal loan, line of credit, or a mortgage. Ultimately money lenders are seeking how likely you are to pay off debt if there was a momentary loss in your income.
For personal finances, the ratio looks like this:
Debt/Equity = Total Personal Liabilities / (Total Personal Assets – Liabilities)
If you take this number and multiply it by 100, you’ll get your debt to equity percentage.
The lower the number or percentage, the better financial shape you are in. And the same goes for most businesses – you don’t want to see this number rise above 2 or 200%.
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How to calculate debt-to-equity ratio
A debt-to-equity ratio formula is pretty straightforward.
Looking at a company’s balance sheet, which is typically published on a company’s website, you take the following numbers and plug them into the formula.
Debt/Equity = Total Corporate Liabilities / Total Shareholder Equity
Again, it’s important to note that a lower number, some say under 2, is preferred by investors.
But sometimes the number can reach a negative – and this also signals a risky investment. A negative debt-to-equity ratio means a company has more liabilities than assets, signalling a possible bankruptcy in its future.
So in summary, investors typically look for a debt-to-equity number that’s under 2 but above 0.
Debt is scary, but sometimes it’s necessary. Learn the difference between good debt and bad debt here.
4 debt-to-equity ratio examples
To see a debt-to-equity ratio in action, look no further than these fictional samples below.
Example 1: Rod’s Catchy Fishing Rods
Rod’s Catchy Fishing Rods is a fishing tackle company (that I just made up).
They’ve recently made headway into the new fishing rod technology market, but they had to borrow money in order to finance the new equipment.
Now, it’s time to uncover whether or not this company is alluring (pun intended) to investors by doing the simple calculation of debt-to-equity ratio.
| Rod’s Catchy Fishing Rods | |
|---|---|
| Total debts | $200,000 |
| Total equity | $500,000 |
| Debt-to-equity ratio | 0.4 |
In this example, it seems like the fishing rod business is booming. Perhaps a sign of what people were doing during the pandemic?
In any case, a 0.4 signals a company that may be able to weather some financial storms when they come. (And besides, you shouldn’t be fishing in a storm anyway.)
Example 2: Barney’s Bean Burgers
Here’s another example of a company, but this time they may not be in the best financial shape and not worth a look as an investor. Barney’s Bean Burgers.
Barney’s has also gone through a growth phase, investing in a new bean burger processing line in an industrial complex outside of Toronto. They’ve racked up some debt doing it…but all signs point to demand in their product so it should pay off.
| Barney’s Bean Burgers | |
|---|---|
| Total debts | $1,500,000 |
| Total equity | $650,000 |
| Debt-to-equity ratio | 2.31 |
At first glance it looks as though Barney’s may be taking on too much debt. But looking long term, an investor would want to keep an eye on the company’s balance sheet to see if that number is growing or shrinking.
A debt-to-equity ratio of 2.31 doesn’t mean you shouldn’t invest in the company point blank, but proceeding with caution would be prudent.
Example 3: Fortis
And now how about a real world example…
Let’s take Fortis, a Canadian Energy Company based in Newfoundland.
Searching their website, you can find their current financial statements here. For this example, we’re looking at page 22 of the 2021 Q1 report, where we can find the following info:
| Fortis | |
|---|---|
| Total debts | 35.268 B |
| Total equity | 20.346 B |
| Debt-to-equity ratio | 1.73 |
The Fortis debt-to-equity ratio is 1.73 which for some makes it an investment worth considering.
But this is just one piece of the pie. You can also consider other parts of the company, such as dividend payout and growth, before deciding to invest with a company.
In the case of Fortis, they currently pay an annual dividend of $1.94 – which is partly why I’ve personally decided to invest.
Example 4: Negative Nelly’s Donut Company
A fictional donut company, Negative Nelly’s, is another company who recently paid out a hefty share dividend to their shareholders.
But now they find themselves in a situation where their equity is negative. Is it a viable business worth investing in? Let’s take a look at their debt-to-equity ratio…
| Negative Nelly’s | |
|---|---|
| Total debts | $100,000 |
| Total equity | -$50,000 |
| Debt-to-equity ratio | -2 |
Negative Nelly’s debt-to-equity number shows a red flag – a negative 2. This negative number, many investors believe, is a sign of financial distress and they may have a hard time financing the debt they’re currently carrying.
No fancy glazing machines in their future!
FAQ
What is a good debt-to-equity ratio?
A good debt-to-equity ratio is one that’s typically under 2 but over 0. This is a common thing investors look for when considering buying shares in a company.
What is the debt-to-equity ratio formula?
The debt-to-equity formula for a business is easy to calculate, simply taking numbers off the company’s financial statement. The calculation is as follows: Total Corporate Liabilities / Total Shareholder Equity. If you’re calculating your personal debt-to-equity ratio, you’ll use your total liabilities divided by your total assets.
What does a negative debt-to-equity ratio mean?
A negative debt-to-equity ratio means that the company has more liabilities than assets – which signals an extremely risky company to invest in. In fact, the company may even be close to bankruptcy.
What does a debt-to-equity ratio of 2 mean?
A debt-to-equity ratio of 2 signals a company that is borderline carrying more debt than they can service. In the event of an economic downturn, they could find themselves in a situation where they can’t meet their debt obligations. This is often considered the highest acceptable debt-to-equity ratio.
What is a debt-to-equity ratio used for?
The debt-to-equity ratio is typically used to examine how leveraged a company is. In other words, are they financing their operations with debt or cash on hand? In the event of an economic downturn, will this company be able to survive while paying all of its current debt? It can also be used by lenders to determine if you’re a financial risk before offering credit.
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