A great sign of prosperity is when a balance sheet shows the amount of long term debt has been decreasing for one or more years. When debt shrinks and cash increases, the balance sheet is said to be "improving". When it's the other way around, it is said to be "deteriorating". Companies with too much long term debt will find themselves overwhelmed with interest payments, a risk of having too little working capital, and ultimately, bankruptcy. Thankfully, there is a financial tool that can help indicate whether or not a business has borrowed too much money relative to the amount of capital the owners have invested in the firm.
Debt to Equity RatioThe debt to equity ratio measures how much money a company should be able to borrow, safely, over long periods of time. It achieves this by comparing the company's total debt (including short term and long term obligations) and dividing it by the amount of shareholder equity. (We haven't covered shareholder equity yet, but we will later. For now, you only need to know that the number can be found at the bottom of the balance sheet. You'll actually calculate the debt to equity ratio in segment two when we look at real balance sheets.
The result you get after dividing debt by equity is the percentage of the company that is indebted (or "leveraged"). The normal level of debt to equity has changed over time, and depends on both economic factors and society's general feeling towards credit. Generally, any company that has a debt to equity ratio of over 40% to 50% should be looked at more carefully to make sure there are no liquidity problems. If you find the company's working capital, and current ratio / quick ratios drastically low, this is is a sign of serious financial weakness.
Long Term Debt Can Be Profitable for Many FirmsIf a business can earn a higher rate of return on capital than the interest rate at which it borrows on its long term debt, it is profitable for the business to borrow money. (An example: If a corporation earned 15% on its investments and borrowed funds at 8%, it would make 7% on the borrowed money [15% return - 8% cost of money = 7% net profit]. This boosts what analysts call "Return on Equity". We will talk about Return on Equity, or ROE, in a future lesson. It is briefly touched on in the Retained Earnings section of this lesson.)
The trick for management is to know how much debt is too much. Leverage can be tricky as it juices returns on the upside, but can wipe out the owners much faster if things go south in an economic recession or depression. That's never a situation in which you want to find yourself when it's your family's money on the line. One way the markets keep corporations in check is by assigning lower interest rates to companies that are perceived as "safer" due to having less debt or more stable cash flows. As a business begins to borrow more and more, it's cost of debt would increase to the point the return calculation changes.
Another major risk that you, the investor, need to guard against is owning a business with a lot of long-term debt taken out when interest rates are low, but needing to be refinanced within the next 5 or 10 years. If the debt comes up for repayment, and the company doesn't have the funds to repay the balance, it's going to require a new debt issuance. In the end, this means interest costs increase, which is going to result in lower profits on the income statement.
This page is part of Investing Lesson 3 - Understanding the Balance Sheet. To go back to the beginning, see the Table of Contents. If you have already read this lesson, you can skip directly to the Balance Sheet Quiz.