If you are considering investing in a company by buying its shares, it’s likely you have heard about the debt to equity (DTE) ratio. This is a type of leverage ratio that measures a company’s financial position in terms of the amount of debt and equity it has.
It is similar to the debt to assets ratio, except it considers the company’s shareholders’ equity instead of its assets. Learning how to calculate the debt to equity ratio is important if you want to figure out which shares are worth buying and vice versa.
In this blog, we will discuss how you can calculate the DTE ratio and use it to make better investment choices. Let’s begin.
What Are Debt and Equity?
As mentioned earlier, the debt to equity ratio measures the liabilities or debt held by a company against its equity. Debt is what the company owes to its lenders. It refers to the money borrowed for carrying out company operations. Some of the typical forms of debt that a company may owe include:
- Accounts payable
- Notes payable
- Credit card debt
- Bank loans
Equity is essentially the value that would be returned to a company’s shareholders if you liquidated all its assets and paid off its liabilities. You can think of it as the company’s book value. Analysts commonly use both debt and equity to determine the financial health of an organization.
The following usually make up a company’s shareholders’ equity:
- Retained earnings
- Common stock
- Preferred stock
How to Calculate the Debt to Equity Ratio of a Company?
Calculating the DTE ratio of a company is fairly simple. You can take the total amount of the company’s debt or liabilities and divide it by the total equity its shareholders hold. When you take the company’s debt, make sure you include both short-term and long-term debts. These are listed on the company’s financial statements.
Next, you can take the company’s equity. Once again, this would include the total capital the company has. You can then divide the total debt by the total equity.
This is what it looks like:
The result will be a decimal or a single-digit, such as 0.7, 1, or 2. A DTE ratio of 1 typically indicates that a company’s liabilities are equal to its equity.
Where can you get this information, though? From a company’s balance sheet. A publicly traded company will share this information via its website.
You can look up the annual report of a company and take a look at its balance sheet for the last 3 to 5 years. The balance sheet should list the company’s total debt and equity. You can input these values into the DTE formula, and voila! You have the DTE ratio.
Many annual reports already have the debt to equity ratio listed, but it’s always good to do your own calculations.
An Example of Calculating the DTE Ratio
If you are unsure how to calculate the debt to equity ratio, this example should help. Suppose that a company has a total debt of $15,000. And its total equity is $30,000. Then, in this case, the DTE ratio will look like this:
How Can You Interpret a Company’s DTE Ratio?
Every industry has different benchmarks for a good debt to equity ratio. This is usually because some industries are more capital-intensive, while others may use more debt financing. Keeping these factors in mind is important when you are trying to analyze a company’s debt to equity ratio.
In the case of the example provided above, a DTE ratio of 0.5 indicates that a company’s debts are half of its equity. Simply put, the investors of the company have funded its assets on a 2-to-1 basis compared to its creditors.
The rule of thumb here is that the lower the debt to equity ratio, the better. A business is more financially stable if most of its assets are funded by its investors, instead of lending institutions.
Debt to Equity Ratio for Investors
If a company has a debt to equity ratio of greater than 1, it is relatively risky for investors. This is because when it comes to debt financing, companies must repay the money borrowed with interest. This can make this form of financing more expensive.
If a company has borrowed large amounts of debt, they may not be able to pay it back, as well. In worst-case scenarios, they will have to file for bankruptcy and as an investor, you are unlikely to see a return on your investment.
Companies that rely more on equity financing are favorable in comparison. This is because companies do not need to pay back the money invested in the company. Instead, they can offer a share in the profits by making periodic dividend payments to the investor.
Debt to Equity Ratio For Creditors
A high debt to equity ratio is bad news for lenders or creditors, as well. In this case, they will see that the company has already accumulated a significant amount of debt. Lending them more money may not be the best move here, because the company may not be able to pay it back.
Moreover, a high debt to equity ratio also suggests that creditors are bearing more risk than the company’s investors. It indicates that investors do not see the company as a good investment, and are therefore reluctant to fund its operations.
The company may also not be performing well, forcing investors to withdraw funding. These are red flags for creditors suggesting they should not lend money to the company.
Wrapping It Up
Learning how to calculate the debt to equity ratio of a company can be a handy tool when buying and selling shares. Remember, the lower the DTE ratio, the better. It indicates that if a company were to liquidate its assets to pay off liabilities, it would also be able to pay its shareholders after the liquidation.
We recommend calculating this ratio for the company’s debts and equity in the last 5 to 10 years. This will give you a clearer picture of the company’s solvency. It can also help you account for debt repayments and increasing or decreasing investments.
We also suggest speaking to a financial advisor for more information on investing and buying shares.
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