The debt to equity ratio is a great formula for investors to use as a rule of thumb for determining the riskiness of a stock, based on its balance sheet.
That said, not all companies with a high debt to equity ratio are risky companies; not all companies with a low (or zero) debt to equity ratio are less risky.
Like many things in the stock market, it all depends—let’s talk about how you can determine for yourself whether a company has a good debt to equity ratio or not, and how you can use that information to make an interpretation on the riskiness of holding that company for the long term.
The Basics of the Debt to Equity Ratio
Before we get into the formulas, understand that the “equity” portion of “debt to equity” comes from the difference between a company’s assets and liabilities.
Equity = Assets – Liabilities
Similar to the equity on a mortgage, a simple definition of equity is what you own versus what you owe. Companies function in a very similar way, though the formula itself takes different forms.
There are two major types of the debt to equity ratio that are commonly used today.
- Long Term Debt to Equity Ratio
- Debt to Equity Ratio (using Liabilities)
Oftentimes, when investors use “debt to equity” terminology they are referring to type #1, the Long Term Debt to Equity Ratio.
Debt to Equity Formula (Type #1)
The formula for Long Term Debt to Equity Ratio is simple:
Debt to Equity = Long Term Debt / Shareholders’ Equity
We can use a free website like quickfs.net to quickly calculate this ratio using a company’s balance sheet. Let’s use Microsoft (ticker: $MSFT) as an example, which has a AAA rating by Moody’s and is a rating reserved for companies with the very strongest financial conditions:
(Apple and Johnson and Johnson are the only other companies besides Microsoft with AAA ratings today; even the U.S. government’s debt does not have a AAA rating).
Clicking to the Balance Sheet tab in the upper right, we can see that in Fiscal Year 2021, Microsoft has Long-Term Debt of $50,074 million, with Shareholders’ Equity of $141,988 million.
Divide 50,074 by 141,988 = 0.35.
The company’s debt to equity ratio in this case is below 1, which is generally considered as a good debt to equity ratio.
The type #2 debt to equity ratio is the exact same formula but substitutes Total Liabilities for Long-Term Debt instead.
The debt to equity which implements total liabilities can sometimes be a better measure of risk because not all liabilities are captured in Long-Term Debt to Equity.
For example, Circuit City had a Long Term Debt to Equity ratio of 0.04 in the year right before they went bankrupt, but because most of their liabilities were in the form of operating leases (rent) and merchandise payable (costs for inventory), they were actually a much riskier investment.
A better measure of the risk in Circuit City would’ve been captured by the second type of debt to equity formula, one looking at total liabilities instead of just long-term debt.
Debt to Equity Ratio Formula (Type #2)
This version of the formula is also simple yet not as commonly used:
Debt to Equity = Total Liabilities / Shareholders’ Equity
Going back to Circuit City, the company had $2,242 million in Total Liabilities on $1,503 million of Shareholders’ Equity.
Dividing 2,242 by 1,503 = 1.49.
This debt to equity is above 1, which makes it not as good of a debt to equity ratio as one below 1. In fact, Circuit City was even more riskier than this because of the huge portion of assets that were inventory instead of cash. I wrote about all those details in my deep dive on Circuit City’s bankruptcy.
Again, interpreting all of these debt to equity ratios can be highly situational…
We will cover why next.
The Best Way to Interpret Debt to Equity Ratio
The problem with shortcuts in the stock market is that they don’t often give you the entire picture. This is especially true with a formula like this.
What you want to do to truly understand a company’s riskiness is to combine multiple pieces of data to paint the picture of the company yourself.
There are two more ratios I use to measure a company’s risk; you can also reference great resources like Moody’s for free to get additional insights.
The two other ratios I use are:
- Interest Coverage Ratio
- Current Ratio
The interest coverage ratio looks at a company’s Income Statement (their “P&L”, or Profit and Loss) instead of their balance sheet to measure their ability to make “minimum payments” on their debt.
It’s very similar to paying off a credit card, except if a company can’t make their interest (“minimum”) payments, they will default on their loan (bankruptcy).
Additional Ratio #1: Interest Coverage
The Interest Coverage ratio looks like this:
Coverage Ratio = Interest Expense / Operating Income
To really get this ratio locked down, you should look at a company’s public annual report, where they are forced to explicitly disclose these pieces of information (read Dave’s great article on how to read an annual report here).
That said, we can still use quickfs.net as a shortcut for most companies. In this case let’s look at another AAA company, Johnson & Johnson (ticker: $JNJ).
Clicking on “Income Statement” on the upper right tab, we can see that in Fiscal Year 2021, the company had the following:
- Net Interest Income = -130
- Operating Profit = 24,547
Net Interest Income can be a substitute for Interest Expense, and Operating Profit or EBIT (Earnings Before Interest and Taxes) are other common names for Operating Income.
Again, substituting Net Interest Income for Interest Expense is not always accurate if a company earns interest on investments, which is why I recommend the annual report numbers. But it works at least for a high level overview.
Taking Operating Profit of 24,547 and dividing by Interest Expense (Net Interest Income) of -130:
=188.82
In other words, Johnson & Johnson can cover its minimum interest payments over 188x; this is way above the recommended ratio for a good coverage ratio of 4.5x (don’t worry about the negative sign, we are just trying to measure how much bigger one number is compared to the other).
The next additional ratio to combine with the Debt to Equity ratio is the Current Ratio, which looks at a company’s short term assets and liabilities (expenses).
Additional Ratio #2: Current Ratio
This ratio is another balance sheet ratio which is simply:
Current Ratio = Current Assets / Current Liabilities
Where this ratio can be extremely helpful is in finding companies where they have enough short term assets (especially cash) to cover their short term expenses (called “current liabilities”). Current Liabilities are ones that have to paid within 1 year; these generally must be paid soon and so the company should ideally have enough cash flowing into the business to cover it.
Let’s go back to Microsoft’s balance sheet to see an example of the current ratio in action.
Clicking the tab in the upper right at quickfs.net for Balance Sheet, we can see the following:
- Current Assets = $184,406 million
- Current Liabilities = $88,657 million
Taking 184,406 and dividing by 88,657 = 2.08.
Like with the Debt to Equity Ratio, a Current Ratio above 1 is generally considered good; Microsoft’s current ratio of 2.08 is considered a very good current ratio.
With my analysis I take the current ratio one step further by reducing inventories (which aren’t guaranteed to be sold for cash) for an adjusted current ratio (“the Quick Ratio”). Again, go back to my article on Circuit City’s Bankruptcy for more insight on how I do that.
Is a High Debt to Equity Ratio Bad?
To recap, in general a Debt to Equity ratio below 1 is considered good.
But as we’ve referenced in multiple examples already, this depends on which type of debt to equity ratio you use and how you combine it with other company risk metrics.
You might be surprised to know…
… that there are some companies that actually aren’t all that risky even with a high debt to equity ratio or even negative debt to equity.
To understand why, you have to understand two concepts:
- Intangible assets
- Stock buybacks
Let’s talk about Home Depot as a great example of this, with a Long-Term Debt to Equity of 35.47 today according to finviz.
A company like Home Depot is valuable because people trust in the wide selection and great prices you can find in stores across the country. In other words, the Home Depot brand name is very valuable in driving sales and cash flows for the company.
But “brand name” is one of those “assets” that aren’t actually included in financial accounting (to really go down the nitty gritty of why, read Dave’s great in-depth guide on intangible assets).
In other words…
Most of Home Depot’s value is not in the assets you can see and measure, like buildings or equipment, but rather the assets which don’t make it to the balance sheet, like brand name and customer trust.
Now, as a company grows its store count, it will cause their assets on the balance sheet to increase. This shows up as “Property, Plant, and Equipment” and can keep a company’s Debt to Equity low as the increase in assets flows to an increase in shareholders’ equity.
But for someone like Home Depot, their number of stores has stayed relatively flat over the last 10 years. They have grown their sales without growing their store count, which has kept asset growth much slower than someone opening lots of new stores like a TJ Maxx.
When sales outpace asset growth, you can get a higher debt to equity ratio especially if the company spends the cash on something like stock buybacks.
Stock Buybacks and Debt to Equity
Home Depot is an interesting case study because their high Debt to Equity Ratio is arguably more influenced by their aggressive stock buybacks strategy than their un-recorded brand name asset.
To understand why, we need to remember what companies can do with profits, which become cash:
- Keep the cash in the business
- Reinvest in assets
- Reinvest through acquisitions
- Pay a dividend
- Buyback shares
Options 4 and 5 are ways to return cash to shareholders. In other words, the value flows to shareholders rather than remaining on a company’s balance sheet.
Both of these options reduce cash, which reduces a company’s assets, which reduces their shareholders’ equity, which reduces their Debt to Equity.
The Bottom Line
That’s where the central theme of this article comes full circle.
A company that sees a higher debt to equity ratio may not always be a riskier investment or a bad company. It could simply be a company which feels safe enough to return more cash to its shareholders, helping raise shareholder returns.
But a company that does this too much may indeed be putting shareholders at risk, especially if there’s not enough of a cash (“liquidity”) buffer left over for the company in case revenues disappear (like we saw with Circuit City).
It’s a balancing act, and many companies manage this well by maintaining a prudent Debt to Equity ratio while also returning cash to shareholders through dividends and buybacks.
The question you have to ask yourself as an investor… Rather than “is this a good Debt to Equity ratio for this company…”
Ask…
“Is this level of debt safe considering everything I know about the business?”
This means considering the other company risk ratios like the Interest Coverage, Current Ratios, and Quick Ratios, but also how you feel about the business in general.
For example…
“Are the cash flows of the company safe and consistent?”
Lots of companies are cyclical in nature, which means their profits ebb and flow as the economy ebbs and flows. A company that doesn’t leave a cash or asset buffer for the valleys of an economic cycle may find themselves in deep trouble if revenues suddenly evaporate.
Not only does that consideration have to do with cyclicality, it also needs a consideration on the company’s competitive advantages. Can the company defend its profits against increased competition, and can it weather a storm if competition eats away at those profits?
Having less debt on the balance sheet means more flexibility for a company in both the short and long term, and this can sometimes mean the difference between thriving or surviving (or not).
