Debt to Equity Ratio
How to use debt to equity ratio
- Lower is better.
- Below 2 is considered healthy (always use industry average).
- Can be very different between industries.
- Can be used to compare companies.
Why do investors use the debt to shareholders equity ratio in their analysis
It shows how much debt the company uses to finance their operations. Shareholders equity is whats left over when you subtract total liabilities from total assets. It's another way to meassure how much of is financed with debt or own resources.
The three steps every investor should look at:
- What is the current debt to equity ratio?
- How does it compare to the industry?
- What is the trend?
Things to be aware of
- Only compare with other companies in the same industry.
- Not all debt is equally risky (for example, short term risk is less risky).
How to calculate debt to equity ratio
Real life example
A real life example of Tesla. You need the following data to determine equity ratio:
- Debt to equity ratio = total debt \ shareholders equity
- $30,855,000 \ $36,376,000 = 0.84
Debt to equity measures the total debt versus the total shareholders equity. While the total debts to total assets ratio uses total assets, the debt to equity ratio looks at the total equity of shareholders. Where equity of shareholders are:
- Common shares
- Preferred shares
- Retained earnings (net profits after dividend payments)
You can find the shareholders' equity in the balance sheet. A ratio between 0,5 and 1,5 is preferred. If the ratio is above 1.5, that would indicate creditors have significantly more stake (debt) in the company than the shareholders. In other words, the company is using a lot of debt to finance their operations.
Not all debt is equally risky. Meaning you can adjust the ratio by including or excluding certain amounts of debt. Short term debts are less risky because they have to be paid back within one year anyway. It’s much easier to plan one year ahead versus five or ten years.
How you think about this?