Trillionaire Term of the Day - January 21, 2009

Debt/Equity Ratio

When companies want to grow, but don’t have enough capital to support their own expansion, they take on debt. They borrow money in an attempt to make their gains bigger than they would be otherwise. The Debt/Equity Ratio (D/E) can be used to determine the extent to which a company takes on debt compared to how much capital it already has.

The most practiced way of calculating the D/E ratio is:

                                                                Total Debt

                                                ------------------------------------

                                                        Stockholder’s Equity

The total debt number is generally comprised of long-term debt. Accounting statements don’t usually include other liabilities, such as accounts payable, in the ratio because the ultimate goal is to calculate how leveraged a company is (how much of their capital is based on debt). You can find Stockholder’s Equity by checking the company’s most recent balance sheet (check Yahoo Finance). Stockholder’s Equity can be described as the total amount of money invested in the company from the initial investors and stockholders.

Let’s take yesterday’s Stock of the Day, Yum! Brands (YUM), to calculate an example D/E ratio. YUM has total debt of 3.62 billion and Stockholder’s Equity of 366 million (both numbers found on their balance sheet). Their D/E ratio is (3,620,000,000)/(366,000,000)= 9.89.

So now that we know how to calculate D/E, we need to be able to interpret it and implement it in our analysis of a stock. A high D/E ratio may mean that a company is taking on a lot of debt to finance more growth. For example, YUM might borrow money and take on debt in order to build more restaurants. Undertaking large amounts of debt to advance opportunities can be risky business, because while gains are multiplied exponentially, losses are also augmented. A low D/E signifies that a company is taking a more conservative route and expanding mostly with the money that they have in current equity.

So should you be looking for a high D/E ratio or a low one when looking into buying shares of a company? The best answer is that it depends on each individual situation. If you’re confident that a company’s expansion will be well received by consumers, a high D/E can be very good. If you believe that more growth would do more harm than good, a high D/E would spell trouble. Let’s use the ratio to analyze YUM.

As we calculated earlier, YUM has a D/E ratio of 9.89.  If you checked out yesterday’s article on YUM, you know that the fast food chain is rapidly expanding on an international level. They’ve taken on a lot of long-term debt to finance their growth. YUM’s is a solid company and it has been doing extraordinarily well overseas. The risk of working with debt is well founded for this company because it is very likely to succeed and increase profits as a result of its growth. In this case, the high D/E ratio is a beneficial aspect.

One last caveat that you should remember is that you must consider what a company does before determining whether a D/E is high or low. Companies that are in industries that require a lot of invested capital (such as airplane manufacturers) have higher D/E’s than companies that don’t require much capital to expand (e.g. tech companies).

The Debt to Equity ratio is yet another device you can use to get a look at what is going on behind the scenes of a company. Understanding and implementing the ratio will bring you one step closer to becoming a superior investor.

 

-Matt Schwartz

College Trillionaire