Good News! Because you are the 85th person to ask a question, we are going to send you a copy of one of my books.

And, you've asked an excellent question -- one whose importance has been made all the more obvious by the Enron debacle and collapse of other companies.

In judging a company's debt load, keep in mind that it's similar to personal debt -- if you run up too much debt on your credit card or get over extended buying property, it can be expensive. It can also be a disaster. So too it is with corporations.

We'll discuss the debt to equity ratio this week and the current and quick ratios next week, so stay tuned.

THE DEBT TO EQUITY RATIO: WHAT IT IS

Debt to equity measures how much debt a company has compared to its equity. That means it looks at how much the company owes and divides it by the firm's equity. (Equity is just the opposite of debt -- it is ownership, including shares of stock in a corporation.)

To state it another way, the ratio compares long-term funds provided by creditors with funds provided by owners -- what a company owes versus the amount of money it has invested in it. It indicates what portion or percentage of equity and what portion or percentage of debt the company is using to finance its business.

WHERE IT IS

Both long term debt and common stock equity are shown on the company's balance sheet. However, an easier way to find the debt to equity ratio is to read the Company Snapshots we provide here on this site. To get a Company Snapshot for any of our stocks, simply click here.

WHAT IT MEANS TO YOU

The debt/equity ratio is important to investors because the more outstanding debt a company has, the greater the proportion of earnings it must use to make payments on the interest and principal. This of course reduces the amount of capital available to help the business grow, to do research, to develop a marketing plan or even to pay dividends to the shareholders.

When a corporation takes on debt, it is locked into making fixed payments, typically twice a year. If it has a bad year, it may not generate enough cash flow to cover the interest payments in which case it must consider selling an asset, raising more money or if the situation persists, possibly declaring bankruptcy.

HIGH vs. LOW RATIOS

A high debt/equity ratio means that the company has been "aggressive" in financing its growth with debt and that it is carrying a sizable amount of interest expense.

A ratio greater than 1 means assets are mainly financed with debt; a ratio less than one means equity provides the majority of the financing.


Ideally, you want to invest in a company where the total debt to equity figure is low -- below .50. However, there are many well-run companies that have a ratio of 1 or even higher. But if the debt-equity ratio surpasses 2, be extremely cautious. Make certain the company can handle its interest payments, and that it has a strong cash flow.

CAUTION: Some companies shift their financing needs to short-term obligations. This makes their long-term debt ratio look better. But, of course, the overall leverage of the firm is the same. Therefore, I recommend that you check the TOTAL DEBT RATIO because this figure includes both short and long term debt.

DEBT NOT NECESSARILY BAD

Debt is not always a negative. A mortgage, for instance, enables people to purchase a house. Ditto for a car and college loans.

So too it is with corporations. The ability to borrow enables small companies to grow into major players and major players to become even more major. But of course too much debt also pushes firms into bankruptcy.

For my Advisory Services stock picks, I usually rate companies with low debt/equity ratios. Click here to learn more about my stock recommendations, and purchase a subscription to my Service, Stocks to Start.






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