How's Your Stock's Health? - Using Debt/Equity to Evaluate it

One way to check is to look at the D/E ratio. That's Debt to Equity. It's a good way to see if a stock has too much debt compared to its equity. Too much debt, like too much of anything, isn't good for a company. By using the D/E ratio, you can quickly tell if a company is stretched too far or whether it warrants more of your attention.

Think of the Debt to Equity ratio much as you would a reading of the arteries in your body. The debt is similar to plaque build-up. If there is too much, the arteries will eventually close, and your soul will have to find another place to live. Debt has the same effect on companies. If there is too much of it and the interest payments on the debt become too burdensome, the company will have to close, much like Iridium recently had to do. It filed for protection under the bankruptcy laws so it can reorganize and work out a deal with its creditors, i.e., the banks and bondholders. Sometimes companies can't work out a deal and simply go out of business. Then the management has to find new jobs, and stockholders have to find new investments, with new money.

However, not all debt is simply categorized as bad. In fact, some debt is good when used prudently. If a company has a reasonable amount of debt, and the interest payments are using only a small portion of the company's revenues, then the company is better off by employing debt and growing the company. As long as the rate of growth of earnings is greater than the interest on the debt, the debt is helping the company expand and not a burden to earnings. Initially, almost every company will make the decision to borrow money only because the numbers show the growth rate better than the interest rate. Sometimes the reality doesn't reinforce the initial numbers. For benchmarks, look for companies that have a D/E ratio of 100% or less. That means, at 100%, the debt is equal to the equity. Some industries require much more debt than equity; the cable industry is one. So if you're looking in a sector that has very high initial capital expenses, the D/E ratio will be off the charts. Don't use this benchmark in those groups. But if you are a conservative investor, looking to avoid highly leveraged companies, then the D/E ratio will tip you off immediately as to whether you want to spend more time on the stock or the group, no matter which sector you're investigating.

If a stock shows a D/E ratio greater than 200%, that means it has borrowed twice as much as its equity base. If something goes wrong with the company, it's the bond holders that have first rights to the assets of the company. When the debt is twice the equity, you know there won't be any assets left for the stockholders if the company goes out of business. So cover your assets by not getting into a stock that's too highly leveraged.