The debt to equity ratio represents the long term debt on the balance sheet divided by the shareholders’ funds. This tells us the proportion of debt to equity or looking at it another way the proportion of assets (minus current liabilities) that are financed by long term debt. Certain companies such as those in asset intensive sectors may tend to take on relatively high debt to finance the purchase of their fixed assets, whereas companies in the service industries may tend to carry lower amounts of debt.
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A comparison of the level of debt carried by companies within a particular industry may give a clue as to those that may be at rather higher risk in the event of tough economic conditions. A company may have a particular reason for taking on more debt than its competitors, for example if it has seen an opportunity for a large profitable project and has taken on debt to finance this, or if it has expanded into a new geographical area or taken over another company. The debt may therefore have been taken on in the expectation that it will lead to higher profits in the future.
Nevertheless a company carrying higher debt may be exposed to more problems if there is a sudden economic downturn or an unexpected catastrophic event that hits the region where it operates. Companies that are operating with a high level of debt rather than equity have taken on an obligation to service the debt by paying interest and ultimately repaying the principal at specified times. If there is a downturn they may have problems in keeping up the payments of interest and principal. A company financed by shareholder equity does not hit the same problem because it is not obliged to pay dividends or to repay shareholders’ funds on ordinary share capital, and is therefore in a better position to weather the storm if a sudden catastrophic event hits the industry or that particular company.
The value investor, who is looking at the intrinsic value of the company and may be assessing future cash flows from its operations, cannot ignore the debt to equity ratio. The obligation to pay interest into the future means that the company must keep generating enough cash to cover the obligation and have enough to spare. The value investor will want to look at the figure for interest cover – the earnings before interest and tax (EBIT) divided by the net interest payable. As a rule of thumb and subject to other conditions an investor would want to see interest cover of more than 2.0 and preferably 2.5 or 3.0, depending on the volatility of earnings. In most tax systems a tax deduction is given for interest paid, subject to restrictions under legislation such as transfer pricing or thin capitalization rules if there is too much debt from related parties. The tax deduction therefore represents an advantage for companies carrying high amounts of debt but the high level of risk remains.
Unlike many other metrics used by value investors the debt to equity ratio is not a measure of profitability but of liquidity. Many potentially profitable companies go out of business because they cannot keep up with their payments in respect of long term debt. A long term investor such as Warren Buffett sees it as a part of good corporate governance and stewardship of a company’s resources to keep debt levels low. If a company becomes over-ambitious, takes on too much debt and is then driven out of business by adverse economic conditions this can be seen as a failure of stewardship towards the stakeholders in the company including shareholders, employees and ex-employees who may be in danger of losing pension rights. Liquidity is a form of insurance against unseen economic dangers.
When the value investor is assessing the intrinsic value of a company and thinking about making an investment while the share price is relatively low consideration should be given to the debt to equity ratio alongside other metrics. Often, the debt to equity ratio will act as a restraint on investor enthusiasm that has been awakened by a favorable price earnings ratio or EV/EBITDA ratio. The corporation may have a successful business model and be in a period of strong profitability but a look at how its operations are financed may bring some reality into the equation. The investor must consider how resilient the company will be if the economic tide turns and becomes unfavorable to the industry. While profitability ratios may be giving the green light to a particular investment the debt to equity to ratio may urge caution.