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.
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.
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