Debt Equity Ratio: What It Is and How It Affects Your Investments

Debt equity ratio sounds like something a financial advisor would throw your direction to make you realize how much you still need him to handle your portfolio. But essentially, if you have anything to do with making your own decisions in investments, you should have at least a basic notion of what debt equity ratio is.

Debt equity ratio has to do with a company’s liabilities and equities. Here’s how it works: Debt equity ratio is what you get when you divide a company’s total liabilities by its stockholder equity. In other words, you divide up a company’s debt by how much asset value its shareholders own.

Using a Debt Equity Ratio to Determine Wise Investments

Debt Equity Ratio

This debt equity ratio can help you determine if a company is a good investment or not. For the company to be a good investment, the result of the division problem should be a very low number, or in other words, a number lower than one. If it is higher than one, it means that the company has leveraged debt to fund most of its asset purchases. This should throw up a red flag to an investor.

If the number is lower than one, however, the company may be a good investment. This means that most of its assets were funded using equity. If it is higher than one, then the company had to take out loans to purchase most of its assets, and that brings the overall value of the company down.

To understand what debt equity ratio is, you probably should understand what equity is. Equity applies to a lot of different financial circumstances, such as home or stock ownership. For home ownership, it stands for the difference between the overall home value and the amount of the mortgage that the homeowner may still owe on the house.

But where the debt equity ratio is concerned, equity is the culmination of all assets, minus the company’s total liabilities. So basically, it is the actual worth of the company in real value, not just paper and numbers.

Looking at Debt Equity Ratio Figures

Now, how does the debt equity ratio affect how you make a determination on an investment? Well let’s take a look at a potential scenario involving a company’s debt equity ratio with a high number. Let’s say a company has $20,000 in debt and $15,000 in equity. The debt equity ratio would look like this: “$20,000/$15,000.” When we divide $20,000 by $15,000, we get 1.33 as a result.

Now remember what we said about the debt equity ratio number being higher than one. This number is certainly higher than one, meaning that the company financed the purchase of its assets with some kind of debt, and that debt is still outstanding. Would it be wise to invest in such a company? Probably not, and here’s why.

What happens if the company cannot repay its debts? In some cases, companies go bankrupt. Although this may not be the case with all companies whose debt equity ratio is over one, it certainly doesn’t bode well for investors. If you want to invest in a company, you should consider that its finances are in good standing and it doesn’t carry a lot of debt.

Now let’s look at a company with a different financial scenario. Let’s assume a company has $5,000 in debt and $15,000 in equity. We would set up the debt equity ratio to look like this: “$5,000/$15,000.” This equals 0.33, and is obviously much less than one.

While the debt equity ratio alone is not enough to indicate whether or not a company’s stock is a wise investment, this scenario certainly bodes much better for you than a company with a high debt equity ratio.

Look at it this way: a company with a low debt equity ratio presents less risk to your portfolio. Even if you don’t understand how the company came up with their numbers or what exactly a liability is versus an asset, you can use this simple equation to determine whether or not the company is a good stock choice.

Another way to look at it is this: pretend the company is an individual, rather than a building with lots of employees and fancy stockholders that drive Porsches. Now let’s suppose that individual owns a mansion in Martha’s Vineyard, a Rolls Royce and a speedboat. From the outside, he looks like a rich person. If you had to invest in a person, this individual – from the outside – looks like he has it together.

But if you look at the finances, you’ll notice this individual has no savings, is several hundred thousand dollars in debt and is about to declare bankruptcy. Does he sound like a wise investment? Certainly not! He’s about to get taken to the cleaners, not pay out healthy dividends to his shareholders.

This is how you can look at a company with a high debt equity ratio. They’re not nearly as worthy of an investment as a company with a low debt equity ratio, no matter how stable they appear on the outside.