A Low Debt to Equity Ratio
High and/or unsustainable debt is never good, and don't let anyone ever tell you otherwise.
Take your household budget for instance...
Do you have a credit card balance? A mortgage? A car loan? Home equity loan?
If you have one or more of these forms of debt, then you probably have minimum monthly payments as well. And those are just the minimum payments. If you want to pay off any of the balances in the next century, then at some point it's necessary to pay more than the minimum.
Now, imagine you didn't have any debt payments.
That's right. Imagine you're completely debt free.
How would this development impact your life?
Well, to start with, you'd have more disposable monthly income. After all, you don't have to pay those minimum monthly payments anymore!
But there's something more.
What does that really mean?
It means ...
After all, as Proverbs 22:7 points out...
Obviously, you would prefer to have zero debt, because no debt gives you the freedom and flexibility to pursue your interests, your dreams, and your desires in life...
Flexibility in Business
If that's the case in our personal affairs, why treat a business any different?
If a lower household debt burden translates into greater personal freedom, then it stands to reason that lower debt load for a business means more freedom for that business. Right?
A company burdened by debt has fewer options at its disposal. Company profits go toward paying off debt and paying back interest instead of going back into the business or into the shareholder's pocket.
In more extreme cases, a company can take on such a large debt load that's its very existence comes into question.
For instance, if a retailer takes on a large amount of debt to finance the acquisition of a competitor, what happens if consumer spending takes an unexpected downturn? Will the company be able to meet its debt obligations? If not, then bankruptcy could be on the horizon...
Now, does that mean debt always bad?
But it still limits a company financially.
Let's review what we learned from the book "Rich Dad, Poor Dad."
How does that apply to a company's debt?
If the company uses debt to finance a poor performing acquisition or to redecorate the CEO's office, then the debt is a liability.
But if the debt is incurred on reasonable terms and used to finance the acquisition of a new business enterprise or a major competitor, and that acquisition yields higher than average returns, then the debt becomes an asset.
The key is knowing the difference, which always starts with asking the right questions.
But first, let's learn how to effectively measure a company's debt load using the debt-to-equity ratio...
What's the Debt to Equity Ratio?
Just like return on equity, let's address this question in two parts...
Earlier, you learned the definition of shareholder equity.
Total Assets - Total Liabilities = Shareholder Equity
That hasn't changed.
But instead of measuring the return on shareholder equity, let's measure the company's relative level of indebtedness by calculating the debt to equity ratio.
Here's how to calculate a company's debt to equity ratio...
Total Liabilities / Shareholder Equity = Debt to Equity Ratio
To find out a company's debt to equity ratio, all you have to do is divide total liabilities by shareholder's equity.
For examples, let's look at the XYZ Company...
Let's say the XYZ Company has $2,000,000 in assets and $700,000 in liabilities.
To calculate its debt to equity ratio, we first calculate shareholder's equity...
$2,000,000 - $700,000 = $1,300,000
So shareholder's equity is $1,300,000.
Now, divide total liabilities by shareholder equity.
$700,000 / $1,300,000 = 0.538
The result is 0.538.
This is the debt to equity ratio.
At this point, you'll probably point out the following...
After all, that's just a number. What can you do with that?
Well, the debt to equity ratio is a key number you can use to your advantage when selecting the right company to invest in. Knowing what the number means and whether or not it's good or bad can make the difference between a fabulous market trouncing investment or a pathetic underperforming one.
Does that sound like something worth learning?
So let's find out what's constitutes a good debt to equity ratio versus a bad one...
What is a Good Debt to Equity Ratio?
Generally speaking, anything under 1.0 is considered a good debt to equity ratio. Anything under 0.5 is great...
But as with return on equity, numbers can be deceiving. Remember, some debt is good. So a high ratio shouldn't, in-and-of itself, be reason to exclude a possible investment opportunity. Instead, it should be a starting point for further investigation.
Ask questions. Ask, ask, and ask again...
If the debt to equity ratio is high, then why is it high? Was the debt incurred for a good cash-producing, earnings-enhancing purchase or for a bad cash-bleeding, earnings-killing purchase? Can the business manage the debt load if industry prospects turn south? Does management have a plan for paying back the debt in a timely manner? If so, how and at what cost?
Investigate, probe, and overturn stones until you find an answer...
Sometimes a high debt to equity ratio scares off investors who see the number but don't investigate further. In some instances, those investors miss out on golden opportunities. Don't be one of them!
In addition, the debt to equity ratio is sometimes incalculable. After all, what if shareholder equity is negative?
In such a scenario, follow the same course of action...
Ask questions. Poke and prod until you find the answer.
You might be pleasantly surprised and find a diamond in the rough.
How Do You Find a Company's Debt to Equity Ratio?
The debt to equity ratio is a commonly used metric you can find on most financial websites. You can find it in the Value Line Investment Survey, and you can also find it in Yahoo! Finance and Google Finance.
For instance, in Yahoo! Finance, enter your company?s ticker symbol.
In the left sidebar under the header 'Company,' you'll find a text link titled 'Key Statistics.'
On the 'Key Statistics' page is a header titled 'Balance Sheet,' where you'll find the following...
It's that easy. But as with any financial information on the web, you should always verify you?re the number from a second source. Even great resources like Yahoo! Finance and Google Finance can sometimes report incorrect information.
Find Companies with Great Debt to Equity Ratios
While you shouldn't consider the debt to equity ratio the most important factor in an investment decision, you should definitely take it into account.
There are lots of solid companies out there with good debt to equity ratios.
But why settle for solid and good?
Go for great!
Find companies with little to no debt.
Find companies with debt to equity ratios between 0.5 and zero.
Don't think they exist?
Here's a few good ones, but there are plenty more...
The Coca-Cola Company (KO)
Nike, Inc. (NKE)
Apple, Inc. (AAPL)
eBay, Inc. (EBAY)
Boston Beer Company, Inc. (SAM)
Hansen Natural Corporation (HANS)
Putting It All Together
So now that you've found a company with great prospects, consistent and growing earnings, high returns on equity, and low debt - are you done?
You've come a long way, but you need to take a few more factors into account.
Because each of these factors is acting like a filter, pulling the bad companies out of your potential investment pool. When you finish, you should have nothing but great companies left to choose from.
At that point, making the wrong investment decision means picking a company which beats the market by only a point or two instead of crushing the market with legendary returns.
So keep reading. Each factor in the common stock investing process you've been is specifically designed to weed out poor investments and leave the best alternatives standing.
So follow the guide and you'll do just fine.
Now, let's learn about another important factor, free cash flow...
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