Before you invest in the stocks of a company over the long term, you need to thoroughly examine its financial ratios. The debt-to-equity ratio of a stock is one such important metric that you need to look into. This ratio gives you an insight into the company’s debt levels relative to its equity.
Typically, the lower this ratio is, the better. A stock with a high debt-to-equity ratio is often considered risky and may not be an ideal investment option.
You can quickly compute the debt-to-equity ratio of any stock using this formula.
Debt-to-Equity Ratio = Total Debt ÷ Total Equity
Here,
Total debt = Short-term debt + Long-term debt + Other liabilities
Total equity = Shareholder’s equity
To understand the concept better, let’s take a look at an example. Let’s say you want to find out the debt-to-equity ratio of a company with the following metrics:
Substituting these values in the above-mentioned formula, this is what you get:
Debt-to-Equity Ratio:
= ₹(15 lakhs + 30 lakhs + 4 lakhs) ÷ ₹58 lakhs
= 0.845
A DE ratio of 0.845 means that the company’s total debt is only around 84.5% of its equity. In general, if the ratio is greater than 1, it means the company has enough cash to pay off its debts. If the ratio is less than 1, the company has more short-term debts than cash.
A high debt-equity ratio means the company has taken on more debt than its equity. This increases the risk of the company being unable to meet its financial obligations. On the other hand, a low debt-equity ratio implies that the company has lower levels of debt than equity, making it a more suitable investment option.
Theoretically, a ratio of less than 1 is considered to be the ideal debt-to-equity ratio for a stock. However, this is hard to achieve, especially when a company is focused on growth and expansion. So, most experts recommend investing in companies with a DE ratio of up to 2.
Anything more than a DE ratio of 2:1 is considered to be too high since it puts the company at risk of bankruptcy.
One of the major advantages of using this ratio in your fundamental analysis is that it gives you a quick overview of a company’s financial position. For instance, if a company has a debt-to-equity ratio of 5, it means that its debt is 5 times higher than its equity.
Such high levels of debt can be a major red flag since the company may not generate enough revenue to pay off its financial obligations. And even if it does generate enough income, the profit margins would be affected due to higher debt repayments.
That said, the DE ratio also comes with its own limitations. It cannot be used to compare companies effectively across different industries. This is primarily because the need for capital and the kind of financing available vary between industries.
Total debt-to-equity ratio is a very important part of fundamental analysis. It is always advisable to consider this metric when evaluating a company’s stocks — whether in the domestic or international market. If you have your eyes set on the US market, in particular, Fi Money makes it easier for you to invest in your preferred US stocks. On Fi Money, you can view all the details of a stock on the stock page in the Fi app, before buying the stock.
Yes. A debt-to-equity ratio of 50% is considered good since it effectively means that the total equity is twice the level of the total debt in the company.
A debt-to-equity ratio of less than 2 is considered ideal for a stock.
No. If the debt-to-equity ratio is high, it means that the company has too much debt relative to its equity. This can be very risky since the company may not be able to service its debt, eventually leading to bankruptcy.
