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Risk Analysis: The Debt-to-Equity Ratio

In his book, "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet", Axel Tracy groups and profiles key investment ratios.

In this digest, we look at a second measure in the Leverage section: the debt-to-equity ratio. We touched on this ratio in a previous article; now we look at it in detail.

The author tells us, "The Debt to Equity Ratio is best used as a strategy measure in that it measures the level of leverage within a business." By leverage, he is referring to how aggressively a company uses debt to speed up its growth. As the name suggests, it measures the amount of debt in relation to the amount of stockholder equity.


He explained that growth starts with the amounts made available by shareholders and the company's retained earnings. Adding debt can accelerate that growth. "The idea behind leverage is that it 'levers' the results of the business. In other words, it allows the business to operate on a scale beyond what the owners or the business itself have financed. The business can use creditors to lever the business to achieve better results than would otherwise be possible."

But, as we've been warned, leverage can magnify losses as well as profits. Debt gone bad can make losses bigger than they would have been without leverage. In extreme cases, businesses fail to provide a return to creditors, i.e. service their debt. When creditors can't be satisfied, bankruptcy is not far behind.

To calculate the ratio, we use this formula:


Debt to Equity Ratio = Liabilities / Equity



For example, if a company has $1 million in debt and $5 million in shareholder equity, then it has a debt-to-equity ratio of 20% (1 / 5 = 0.2). For every dollar of stockholder equity, the company has 20 cents of debt. Data for both liabilities and equity are found on the balance sheet.

GuruFocus users will find the debt-to-equity ratio in the Financial Strength section of the Summary page for each stock. Here's an example of McDonald's (NYSE:MCD):

We see the ratio for McDonald's is minus 6.65; what does negative debt-to-equity mean? Returning to the formula above, we note that when debt is less than equity, it results in a positive number; thus, negative debt-to-equity shows there is more debt than equity.

Should we be alarmed, then, by McDonald's negative ratio? Let's look at another ratio in the GuruFocus Financial Strength section: WACC vs ROIC. WACC is weighted average cost of capital (how much the company needs to pay for its debt and equity funding), while ROIC refers to its return on invested capital. Note again that WACC includes both debt and equity costs, so it is not a perfect complement to the debt-to-equity ratio.

Looking at the numbers we see: "ROIC 23.27% WACC 3.45%". A quick calculation tells us that McDonald's is earning $6.70 (23.27 / 3.45 = 6.7) for every dollar of debt and equity it holds. Thus, borrowing (or leverage) has made this company more profitable. And, should it experience a financial hiccup, it's history and financial strength should mean relatively easy access to lenders or new equity.

As with other ratios, the debt-to-equity ratio can change from quarter-to-quarter or year-to-year. All it takes is a change in the level of debt and/or equity. Tracy wrote:


A change in the Debt to Equity Ratio represents a change in 'gearing' or 'leverage'. This normally occurs due to a deliberate change in how the business will fund its growth. A higher level of leverage (a higher Debt to Equity Ratio) can often accelerate growth than would otherwise be the case. This is because more cash-generating assets can be funded (by the extra debt) which would ideally increase the speed that the assets can generate returns while keeping the level of stockholder funds the same.



He also addressed the negative side of having a high debt-to-equity ratio:


While leverage can increase growth it can also 'lever' the losses if the business plan does not work out. Higher debt will require higher interest payments and when a business is performing poorly these high interest payments can be a large burden than would otherwise be the case. Generally, a company only goes out of business due to debt it cannot service, therefore high debt can lead to possible collapse which would not be the case if funds were raised through equity issuance and retained earnings.



As with the other ratios we have seen so far in Tracy's book, there is no optimal level. Even when you calculate the ratio, there is no correct, black and white spot, it's always shades of gray. The level will depend on issues such as internal company policies and on the person doing the analysis.

If company policy is a factor, then an analyst must also consider the industry, the lifecycle of the business and more. If we drop to the lifecycle level, then an analyst may consider whether this is a young company that wants to grow rapidly or a mature company taking advantage of low interest rates. A wealth of variables constrains the use of the debt-to-equity ratio as the last word on the relationship between debt and equity.

Conclusion

The debt-to-equity ratio is a useful tool for investors because it provides a snapshot of a company's use of leverage. Many companies find leverage helpful because it allows them to accelerate their growth and profitability beyond what they could do with equity alone.

Leverage also can be dangerous, because it may force a company to shoulder heavier interest payments and that, in turn, can make it harder for a company to cope if there is an internal or external slump.

In the digest, we also introduced another ratio: Weighted average cost of capital versus return on invested capital (WACC vs ROIC). It can help investors understand how effectively a company is using its debt.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.