What is it
The debt-equity ratio of a company is calculated by dividing the company’s total liabilities by the total equity fund belonging to shareholders. It is a measure that reflects the proportion of equity and debt that the company has employed to finance its assets. Usually only long-term debts are considered while computing the ratio.
A high ratio would mean that the company has been aggressive in taking the debt route to finance its assets. The ratio is generally high in capital-intensive industries as they need huge capital infusion to expand. A high debt-equity ratio does make the earnings volatile because of the high interest that needs to be paid for the debts taken. However, if such debt helps increase the earnings of the company in such a manner that the debt cost gets adequately covered, it is good for the shareholders since a share of this increased earnings would go to them as well.
A low ratio would mean that the company has availed a small amount of outside financing or debt and is dependent more on its cash reserves and money raised through the equity route. This situation is generally witnessed in industries where the capital requirement is low. For instance, a software company. A low ratio means that the company is self-sufficient in undertaking its expenses. In some cases, it may also mean that it is a defensive company and hence future growth prospects may not be strong.
What it means for you
It is not always bad for a company to have a high debt-equity ratio at a particular point of time. However, an investor should look at the trend. If the ratio has remained high for a significant period of time or has been increasing steadily, then it is a red flag for you. Dig deep into the fundamentals of the company before investing in it. Tough outside financing increases the earnings of a company, a high ratio over a long period of time would mean mounting debts that ultimately may wipe out the gains generated through such financing.
Also, remember that this ratio is not the only criteria for picking a stock. There are many other parameters, such as return on equity, management and earnings per share, that should be analysed before you make a buying decision.