The Debt-to-Equity Ratio explained.

The Debt-to-Equity ratio (D/E) is a “leverage ratio” that measures the weight of total debt and liabilities against total shareholder equity. A company’s financial leverage is an important metric to monitor as debt can make or sink companies. It is an indirect way to assess the degree to which a company finances its operations rather than funding from profits or dilution.

A higher Debt-to-Equity ratio indicates a heavier reliance on debt as opposed to equity. However, it is important to understand the industry and the business cycle to determine whether it is good or bad. Certain industries are going to have higher D/E ratios due to the capital intensity of the business. For instance, a logistics company that has a fleet of trucks, a utility business expanding infrastructure, and a manufacturer setting up a new warehouse are all capital-intensive and often debt-intensive. On the other hand, a SaaS company or a professional service business in a light capital intensity sector will have a lower D/E as it does not depend on a lot of debt to grow.

As a micro-cap and small-cap investor, I prefer companies with no debt at all. Sometimes very low debt is acceptable, but the vast majority of my holdings are debt-free and cashed up. The reason why I look at the D/E in the bottom end of the market is because it is highly volatile, a lot more aggressive with competition, and there are a lot more variables that can sink early-stage businesses. Debt just adds a huge unnecessary burden to a small business trying to grow, and one way of eliminating a contributor to risk is to avoid debt-ridden companies. “Travel light, travel far” is what I believe works best for smaller businesses.

However, if I spot a business in the mid to large-cap space that has a robust business model and consistency in earnings, then I want to observe the D/E closely to see if it is using the debt wisely to expand.

It is important to understand that too many investors create the idea that high is bad and low is good and base their entire investment strategy on metrics without understanding the underlying business, the capital requirements, and the need for debt.

For example, we find a company that has a low D/E ratio and assume it is good based on low financial metrics. If we dig deeper and reveal that this company has a low use of debt in an otherwise debt-fueled industry with its peers all showing higher D/E ratios, we want to know why that is. Perhaps it reflects management being too conservative and not using debt efficiently to expand. Capital allocation is not being optimized.

It is easy to assess if a company with a low debt-to-equity ratio is being efficiently run. Usually, companies that have strong earnings, a lot of cash, and prudent capital allocation have a lower ratio. If this company does not have these characteristics, then something else is wrong.

Over-relying on equity financing can be costly and an inefficient way to fuel growth. Dilution is not the friend of the shareholder unless it is done diligently. The debt-to-equity ratio can help investors paint a better picture of the opportunity.

What is the Debt-to-Equity formula?

• Debt-to-Equity = Total Debt ÷ Total Shareholders Equity.
• Both are found on the balance sheet.

Total Debt: The debt component is made up of any short-term borrowings, long-term debt, and any debt-like items on the company’s balance sheet. Not all current and non-current liabilities are considered debt. Some analysts will reconfigure the debt component to reflect the true operating debt of a business.

Shareholders Equity: The equity component is made up of any equity contributed by equity raised in the capital markets (shareholders), and retained earnings.

*Depending on the type of company being researched or valued, reconfiguring the debt component by removing areas that are not considered key to financing operations. Areas such as accounts payable, accrued expenses and dividends payable are not considered debt. Some analysts will create a “debt ledger” of the liabilities and take out what they feel is not necessary for each of the inputs to get a very accurate look at the overall debt to equity.

How to use the D/E ratio?

Debt Capital is important and business that don’t use debt financing wisely may be neglecting growth opportunities. The benefit of debt is that it is often cheaper than equity and allows businesses to leverage a small amount of money and repay it over time. The interest paid on debt is often tax-deductible and equity capital is not.

In our first example let’s examine three companies to look at which business has a better Debt-to-Equity ratio compared to the industry average of say 1.5x and what “may” qualify for further due diligence.

D/E	Company A	Company B	Company C
Total Debt	$485 million	$623 million	$1.05 billion
Shareholders Equity	$1.2 billion	$274 billion	$86 million
Debt-to-Equity	0.40	2.27	1.18

The metric translation simply means that Company A has 0.40 cents of debt for every $1 of equity. Company B has $2.27 of debt for every $1 of equity, and Company C has $1.18 of debt for every $1 of equity. If we were presented with these three companies and were looking for the right candidate, we could start with Company A. It reflects a company that has less debt than its peers, which can be due to various contributing factors. However, in this case, we could assume that it is not taking advantage of debt to help finance growth like its peers.

On the other hand, Company C could indicate that it is taking on too much debt compared to the industry average and its peers, making it riskier with its leverage. Finding the right balance is essential when using debt to grow. Too much debt can lead to financial distress, making it difficult for a company to pay its debtors.

Purely based on the D/E without further analysing all the other valuation contributors, Company C looks to be the most aligned with the industry average as well as the right balance of equity and debt. If a company has a D/E of 1 it means creditors and investors are considered equal in the company’s assets.

Let’s look at another example of a company to see if it is efficiently growing using debt and equity.

	2021	2022	2023
Cash + Equivalents	$75m	$80m	$88m
Inventory	$35m	$37m	$37m
Accounts Receivable	$40m	$42m	$45m
PP&E	$90m	$90m	$90m
Total Assets	$240m	$249m	$260m
Short-Term Debt	$10m	$11.5m	$13m
Long-Term Debt	$50m	$65m	$83m
Total Debt	$60m	$76.5m	$96m
Total Equity	$195m	$197.5m	$204m
Debt-to-Equity	0.30x	0.38x	0.47x

In this simplified balance sheet, we can see the Debt-to-Equity rising steadily each year in line with shareholders’ equity striking that balance between using debt and equity to grow. When looking at the D/E it is important to see the changes in the debt levels and shareholders’ equity over time. Consistency and stability are key and look out for lumpy year-on-year changes. We don’t want massive spikes in the D/E, going from 0.47x to 3.5x can indicate a company taking on unnecessary debt.

Debt when managed prudently and allocated to the right areas can have wonderful results on long-term equity growth. Not managed correctly and well…you know the ending to that story.

In Summary…

Trends show that businesses are growing due to a healthy balance of debt and equity. Getting that combination right anywhere (in my opinion) between 0.5x to 1.5x strikes a good balance. In the private markets where I have spent 14 years, a lot of firms would aim for no more than 0.5x leverage. It gives them enough capital to grow and yet not enough to sink them should the markets turn. Debt that is prudently allocated can reap huge returns for shareholders.

A high debt-equity ratio can be considered good because it may show that a business can easily service its debt obligations from cash flow and is using the leverage to increase equity returns. One important thing to remember is that debt can fuel a high Return On Equity, this is because debt is cheaper than equity and the equity account will be smaller. This also brings the Weighted Average Cost of Capital (WACC) down.

Here is how I would view a high D/E ratio. A mature company with slowing growth is not good unless it has huge cash reserves to service high debt levels. Big companies with high D/E ratios can collapse quickly in a market downturn. On the other hand, a smaller hyper-growth business with a high D/E may be using the debt wisely to fuel rapid expansion without diluting equity holders.

A company with a D/E ratio higher than its industry average might struggle to also borrow money from new lenders. This as an investor is something to watch closely. Companies grow and survive based on the ability to raise capital and fund growth, if a company needs capital and cannot borrow then it is a matter of time before the doors close. As investors we look at certain “turn-offs” when it comes to an opportunity but so do creditors.