April 21, 2023
Understanding the financial health of a company is essential for the individual investor. Publicly-traded companies are required by federal law to submit a balance sheet, income statement and cash-flow statement several times each year. The debt and equity numbers gleaned from the balance sheet can be used by the retail shareholder to understand more about a company’s financial health.
Debt and equity are key components used to determine a company’s financial health. Determining a company's debt-to-equity (D/E) ratio is as simple as dividing its total debt by its shareholder equity. Also called a leverage ratio, the D/E ratio is used to illustrate the amount of debt a company has incurred. Determining the D/E ratio will give insight to show if a company is able to meet its financial commitments by revealing how much of their capital comes from debt.
A company with a higher leverage ratio has more debt, which can indicate a potential problem as these results may suggest that the company is relying on excessive debt to finance its operations, and may be not able to repay its debt, putting it at risk for bankruptcy.
Leverage ratios can vary by industry. Real estate, energy and finance have higher acceptable leverage ratios than other industries, simply because of the nature of what they do.
These industries typically have higher debt-to-equity ratios because the companies tend to leverage a lot of debt – for example when granting loans – to make a profit. There are companies that leverage a large amount of debt to build strong, long-term growth and individual investors who get in early can potentially reap higher than normal returns. In contrast, the service industry has lower debt-to-equity ratios because they have fewer assets to leverage.
Robert R. Johnson, professor of finance in the Heider College of Business at Creighton University and the founder of Economic Index Associates says that "Interpreting debt-to-equity ratios is a bit of art mixed with a dash of science. The higher the debt-to-equity ratio is, the greater proportion of a company's finances comes from debt. It's true that the higher the ratio, the more the company relies on debt financing."
The retail shareholder will need to learn the leverage targets to be able to make an informed prediction. Financial advisors generally say that a D/E ratio of 0.5 or less is ideal. Put simply, no more than half of the company’s assets should be financed by debt. The more debt you have, the higher your ratio will be. A ratio of 2 or 2.5 is considered good, but anything higher than that is considered an undesirable and a ratio between 5 and 7 is ranked in the “high” zone.
In some cases, individual investors may be steered toward companies with a higher D/E ratio, especially when leverage is used to finance its growth. When advisors recommend this route, it is typically because the company can potentially generate more earnings than it would have without debt financing. Investors can reap rewards if leverage generates more income than the cost of the debt. Interestingly, a lower D/E ratio isn't always a positive sign 一 it can mean a company is relying on equity financing, which is significantly more expensive than debt financing.
Sometimes more fiscally conservative investors prefer companies with lower D/E ratios, especially if they pay dividends. It is important to note that for companies that pay dividends, having a lot of debt greatly affects the possibility that they might have to cut their dividend during volatile periods. If a company takes on debt to keep its dividend going, that's a red flag. Financially healthy companies should be able to pay out dividends from their profits, not from taking on debt.
Once you’ve determined the debt-to-equity ratio for a prospective investment, set it side by side with other companies in the same industry. Comparing whether the company’s D/E ratio is close to the industry average will help the individual investor to determine their next investment choice.
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