Debt to Equity Ratio
The debt-to-equity ratio ("D/E") is used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity. In other words, it measures how much a company is financing its operations through debt versus its own funds. However, it also reflects the ability of shareholder equity to cover all outstanding debts in the event of a severe business downturn.
How can I use the debt to equity ratio when investing in stocks?
- You can use the debt to equity ratio to determine the risk profile of a stock. Firms with a higher debt to equity usually indicates that their stocks are more exposed to risk through financial leverage. While high risk may lead to higher returns, it may incur huge losses during a market downturn. For example, Bank of America has a debt to equity ratio of 8.19. This means that only approximately 10% of the assets that it invests in are its own shareholder's equity. Let's say it invests a total asset of $100,000, with $10,000 as its shareholder's equity and in 1 year, the amount doubles to $200,000. The firm would have made a 1,000% return after paying its liability. Without leverage, the return would only be 100%, reflecting a ten times higher return because of leverage. However, if the asset depreciates by half to $50,000, the firm would have incurred a loss of 500% after paying its liability – while without leverage, the loss would only be 50%.
- Similar to other financial ratios like current ratio and return on equity, the debt to equity ratio cannot be measured in absolute terms. Companies in the financial, oil and gas, and telecommunications sectors usually have a higher debt to equity ratios as they are capital-intensive industries and require significant financial resources and large amounts of funds to produce goods and services. Banks rely heavily on debt financing to offer loans to their customers, oil and gas companies require large sums of money to build storage facilities and purchase refinery equipment, and telecommunication companies need significant investments in infrastructure. Thus, a good gauge of a company's risk or leverage is to compare it with its industry's average.
Debt to Equity Ratio
Used to evaluate a company's financial leverage and is calculated by dividing a company's total liabilities by its shareholder equity.
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