In his book “Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allows You to Analyze Any Business on the Planet”, Axel Tracy gathers and profiles the main investment ratios.
In this summary, we look at a second metric in the Leverage section: the debt ratio. We discussed this ratio in a previous article; now we examine it in detail.
The author tells us that “the debt ratio is best used as a strategic measure in that it measures the level of indebtedness within a company”. By leverage, it refers to the aggressiveness with which a company uses debt to accelerate its growth. As the name suggests, it measures the amount of debt versus the amount of equity.
He explained that growth begins with the amounts made available by shareholders and the company’s retained earnings. Adding debt can accelerate this growth. “The idea behind leverage is that it ‘leverages’ the bottom line of the business. In other words, it allows the business to operate on a larger scale than the owners or the business itself has funded. The business can use creditors to leverage the business for better results than would otherwise have been possible. “
But, as we have been warned, leverage can magnify losses as well as profits. Debt gone bad can lead to greater losses than it would have been without leverage. In extreme cases, companies fail to repay their creditors, that is, to pay off their debt. When creditors cannot 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 equity, then it has a debt-to-equity ratio of 20% (1/5 = 0.2). For every dollar of equity, the company has 20 cents of debt. Data relating to liabilities and shareholders’ equity appear in the balance sheet.
GuruFocus users will find the debt ratio in the Financial Strength section of the Summary page for each stock. Here’s an example from McDonald’s (NYSE: MCD):
We see that the ratio for McDonald’s is minus 6.65; What does a negative debt ratio mean? Returning to the formula above, we note that when debt is less than equity, it gives a positive number; thus, a negative debt-to-equity ratio shows that there is more debt than equity.
Should we be alarmed then by McDonald’s negative ratio? Let’s look at another ratio in the Financial Strength section of GuruFocus: WACC vs ROIC. WACC is the weighted average cost of capital (how much the company has to pay for its debt and equity financing), while ROIC refers to its return on invested capital. Note again that the 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 math tells us that McDonald’s earns $ 6.70 (23.27 / 3.45 = 6.7) for every dollar of debt and equity it holds. So borrowing (or leverage) made this business more profitable. And, if there is a financial problem, its history and financial strength should mean relatively easy access to lenders or new stock.
As with other ratios, the debt ratio may vary from quarter to quarter or from 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 happens due to a deliberate change in the way the business will finance its growth. A higher level of debt (a higher debt ratio) can often accelerate growth than it would otherwise. This is because more cash-generating assets can be funded (through additional debt), which would ideally increase the speed at which the assets can generate returns while maintaining the same level of shareholder funds.
He also touched on the negative side of a high debt ratio:
While leverage can increase growth, it can also “leverage” losses if the business plan doesn’t work. Higher debt will require higher interest payments, and when a business is performing poorly, those high interest payments can be a greater burden than they would otherwise. Typically, a business only goes out of business because of a debt it cannot repay. Therefore, high debt can lead to a possible collapse, which would not be the case if funds were raised through stock issues and retained earnings.
As with the other ratios we’ve seen so far in Tracy’s book, there is no optimal level. Even when you calculate the ratio there is no correct spot, in black and white it is still shades of gray. The level will depend on issues such as internal company policies and who is performing the scan.
If company policy is a factor, then an analyst must also consider industry, company lifecycle and more. If we go down to the lifecycle level, then an analyst might wonder if this is a young company that wants to grow quickly or a mature company that benefits from low interest rates. A multitude of variables limit the use of the debt ratio as the final say on the relationship between debt and equity.
The debt-to-equity ratio is a useful tool for investors because it provides insight into a company’s use of leverage. Many companies find leverage to be useful because it allows them to accelerate their growth and profitability beyond what they could do with equity alone.
Leverage can also be dangerous as it can force a business to take on higher interest payments and this, in turn, can make it harder for a business to cope with an internal or external crisis.
In the digest, we have also introduced another ratio: Weighted average cost of capital versus return on invested capital (WACC vs ROIC). This can help investors understand how effectively a business is using its debt.
Disclosure: I do not own any shares in any listed company and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.