Role of 'debt to equity' ratio in stock investing

debt to equity
Debt to equity basically is a number which shows how many times a company’s debt is, as and when compared to its equity. During the initial public offering(IPO) suppose the company issued 30 lac (30,00,000) shares of face value 10 each. So it’s equity is 3cr (3000000 * 10). We are not considering retained earnings here though retained earnings are also the part of the shareholders' equity.

It means the company borrowed Rs.3 crore from the general public who bought 30 lac shares of the company @Rs.10 per share. But sometimes this kind of borrowed money (by issuing shares to the general public) is not enough to run company’s business operations.

So the company is forced to borrow more money from the financial institutions like banks and banks as you know don’t lend money without charging interest. So this kind of loan taken by paying fixed annual interest becomes the debt of the company. However, it doesn’t cost any interest to the company on the equity as the general public were issued the shares of the company which they can sell any time in the open market to make money.

Suppose the debt (loan taken on interest from banks or other financial institutions) in the balance sheet of the company is 6 cr. while the equity is 3 cr. It simply means the company’s debt is 2 times of its equity (2 * 3=6cr) and so the debt to equity ratio is 2.

The debt to equity ratio of 2 or more is usually considered high in the stock investing and so the cautious investors avoid investing in such stocks with high debt to equity ratio. The simple reason is more the debt on the company more it has to pay the annual interest which will eat away their profit margins and without the rising profits, as you know, the share price cannot rise.

Best is to invest in a company with debt to equity less than or equal to 1. You can check all the financial data of any company you want by making use of the search box as mentioned on the top banner of this site. Among that data, you can also check the debt to equity ratio.

Sometimes high debt to equity ratio is not much of a problem if the company is still able to make good profits after paying the annual interest. It’s even better if the company is able to pay its debt also on a regular basis from the earned income.

You can check this in the past 5 years data of the company whether the debt to equity ratio is lowering or not YOY basis. It all depends on the business model of the company whether the high debt to equity ratio is still sustainable or not for the company. But it is for sure investing in companies with high debt to equity ratio is riskier than those with low or zero debt to equity ratio.

If a company is operating in a competitive niche with thin margin and if it’s debt to equity ratio is high then it’s better to avoid buying the stock of such a company as it could go bankrupt any time.

On the other hand, if there is a monopoly of company's products in the market then nothing much to worry about high debt to equity ratio as monopoly businesses always do better in terms of profits.

Written By: Rajesh Bihani, senior writer at sharemarkethow.com.

Disclaimer: All the information compiled and presented here on this site is based on our financial background knowledge, years of practical experience, and recent research. But still we are not legally authorized to recommend stocks and so the information should be taken as our personal views only.