There are many ratios and metrics involved when one analyzes a set of financial statements from a company. But one very important metric which can help you determine if the company may be biting off more than it can chew is the Debt-Equity Ratio (DER).
The DER is defined as the ratio of the total amount of debt a company has on its balance sheet, divided by its equity base. Debt, as we all know, represents the total amount of borrowings a company has – and remember that interest has to be paid on all types of borrowings, be they bank loans, bonds, or debentures. Equity, on the other hand, represents the amount of capital contributed by the owners of the company, otherwise known as shareholders. The DER therefore tries to calculate and determine the amount of borrowings the company has with respect to the amount of capital being injected.
Let’s look at an illustration. Assume Company A has short-term debt of $100 and long-term debt of $200, while total equity is $500. Using the formula above, the DER will be 0.6. Here’s the math:
DER = ($100 + $200) / $500 = 0.6
The DER is almost always written in the form of a ratio, rather than percentage (which applies more to the margins of a company, such as the gross margin and operating margin).
Let’s now assume Company B has short-term debt of $400, long-term debt of $600, and equity of $500. Its DER would thus be 2.0.
Just based on the DER alone, Company B would be riskier than Company A as it has more debt per unit of equity – in other words, Company B has obligations which exceed the amount of capital injected into the firm. Of course, other metrics have to be looked at too for a holistic assessment – the cost of the debt, the tenure (length of maturity) for the debt, the industry each Company operates in, as well as the companies’ overall balance sheet strength.
But the DER still represents a quick way to judge if a company may be borrowing more than it should be, or if it is conservatively financed. No borrowings may also not be a good thing for a company, as cash itself earns shareholders an almost zero return; but excessive debt would signal that a company may get into trouble should a recession hit, or when tough times arrive.
In the near future, I will be sharing more important metrics and ratios an investor should look at when analyzing companies for investments, so stay tuned!
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.