Assessing a Company’s Debt-to-Equity Ratio
If you have ever in your life read anything related in investing then you have heard the term Debt-to-Equity ratio.
The debt-to-equity ratio measures how much money a company should safely be able to borrow over long periods of time. It is determined by comparing the company’s total debt (including short-term and long-term obligations) and dividing it by the amount of shareholder’s equity. For now, you only need to know that shareholder’s equity can be found at the bottom of a balance sheet.
Shareholder equity, also referred to as owners’ or stockholders’ equity, is the net worth of a company. It represents the stockholders’ claim to a business’s assets after all creditors and debts have been paid. It can be calculated by taking the total assets and subtracting the total liabilities. Shareholder equity usually comes from two places:
1. Cash paid in by investors when the company sold stock.
2. Retained earnings, which are the accumulated profits a busi- ness has held on to and not paid out to its shareholders as dividends.
Because these are the two ways a company generally creates shareholders’ equity, the balance sheet is organized to show each part’s contribution.
The result you get after dividing debt by equity is the percentage of the company that is indebted (or leveraged). The normal level of debt to equity has changed over time, and it depends on both economic factors and society’s general feeling toward credit. Generally, any company that has a debt-to-equity ratio of more than 40–50 percent should be looked at more carefully to make sure there are no liquidity problems. If you find the company’s working capital and current/quick ratios are drastically low, this is a sign of serious financial weakness.
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