Debt can be a deadly toxin for common people, but in corporate world that just isn't the case. Contrary to the popular belief, debt doesn't always bleed a firm, instead in many cases it helps them grow. Add to that, debts are one of the easiest ways to finance business for scaling up through cash.
But this isn't some corporate utopia, where debt is always seen in the best interests of a company. Situations usually tend to go out of order when the management team fails to regulate debt methodically.
How to select businesses that manage debt efficiently is what this blog on debt to equity ratio will cover. But first, do check out the previous blog about return on equity, which is a top stock picking metric among the mogul investors like Ray Dalio and Warren Buffet.
"Debts are like children - begot with pleasure, but brought forth in pain"
In the fast-paced world of finance this basically translates to borrow in line with how much you can pay back. Precisely put, a simple measure of how much debt a company uses to run the business. There! You have the simplest definition of debt to equity.
Now that definition is out if the way, question arises that how does one calculate this ratio?
Once the definition is clear calculation becomes a piece of cake. Debt to equity ratio is calculated by dividing the total debt or the liabilities of a company by the shareholder's equity.
Consider a hypothetical scenario wherein 2 companies A & B belong to the same industry:
1.) Company A has a net debt of 100cr and total investor equity of 200cr. So, the Debt-Equity comes out to be 100cr/200cr which is 0.5
2.) On the other hand, Company B has a debt of 400cr and shareholder equity of 200cr, its ratio comes out to be 400cr/200cr, i.e. 2
Form this, one can easily conclude that company A is managing its finances more efficiently as compared to Company B. So naturally an investor would want to invest in B thus, adding to the equity which will further decrease its ratio.
Usually a high ratio would mean that company is borrowing more to finance its operations due to lack of cash flow and shareholder equity.
A low ratio on other side would mean that the company is running itself just from the shareholder's money and doesn't need to borrow from the bank in order to operate.
What is the ideal ratio? Well that would depend industry to industry. There are manufacturing industries like metal & automotive which require a lot of initial capital in order to start their operations, thus incurring a lot of debt initially.
Then there are less capital-intensive industries centered around providing services and minor products like IT & Fast Moving Consumer Goods (FMCG) which don't require as much initial capital to fund their business, so their ratios would be much less compared to companies in metal or automotive industry.
Fun Fact : Some companies have zero debt - equity ratio, indicating that they are either debt free or have minimal debt compared to the investor backed money. They therefore manage their finances & operations smoothly. But don't invest blindly! Factor in other metrics too, and that will give the whole picture. Never ever base decisions on one ratio.
While picking companies based on their debt-equity ratio, be extra careful while comparing. Ensure that contrast is between companies of the same industries. Comparing companies from different industries wouldn't be apples to apples due to the fact that each industry functions differently and thus companies of those industries operate differently. So, the next time you choose which company to invest in, keep this article handy so that Mr. Market doesn't rip you off!
Note : All images used in this post has been taken from Google Images and the copyright of each of the images lies with their copyright holders.