Decisions with Debt and Equity

Decisions with Debt and Equity

Decisions with Debt and Equity

This is a subject that is short and sweet. It’s one that may seem obvious to some analysts but is still one that is over looked by many; and that is the interpretation of the Debt/Equity Ratio (D/E).

Typically this ratio is made up of Total Liabilities divided by Total Shareholders’ Equity (including retained earnings). So basically, for each piece of equity, or money, that the company has, the ratio tells us how much of it is financed by debt. This can be a great measure of how durable a company is and whether there is a competitive advantage. But beware that it isn’t misinterpreted.

It is valuable to note that some companies use their equity to buy back shares. So in order to make the analysis viable and fair, the treasury stock (stock buybacks) should be added back to the denominator of the equation, and therefore give us the “Adjusted Debt-to-Shareholders Equity” ratio. There is a possibility that a company would use all of their equity to buy back stocks, leaving shareholders’ equity at zero or negative, and, making the ratio irrelevant. If we adjust across the board then we will have a more usable and accurate number.

It is very clear that a company with a low ratio is favoured because they don’t incur debt in their business. Debt is something that could cause an issue for a firm if it has trouble paying that money back. The tricky part here is that there is a possibility for great companies to have high D/E ratios.

Great businesses shouldn’t have to finance their operations with debt. In fact, a company with a competitive advantage usually has enough earnings power that it uses this power to finance the operations. This earnings power (what would be retained earnings) will give these types of companies a low shareholders equity number driving the D/E ratio up. None of their profits are being retained into the shareholders equity because they don’t need to do that. If push comes to shove and this firm needs to raise capital, they can very easily do that through operations because the economics of the business are so strong.

We must be careful of such scenarios when we do company analysis because we might miss a great firm and label it as a bad investment. Another example of how the D/E ratio can be misinterpreted is within the banking industry. Banks are typically a fairly reasonable business. They provide a service people will most likely require into the unforeseeable future (like lawyers and doctors). They can’t be completely eroded away by machines (granted, some of their service could be) or replaced by ones self. Banking requires a skill set that is dependent on an education that not everyone chooses to take and it also requires a level of personality that consumers demand which a machine also can’t replace. Yes, some banks are much worse (and some implode) at their business, but from a broad perspective of the concept they’re needed and have a moat. But, if an analyst were to look at banks simply with the D/E ratio, he would very quickly dismiss them. Banks incur a lot of debt. But this is part of their business. They aren’t incurring this debt because they require it to stay afloat but because they are in the business of loaning money. An inaccurate assessment could very surely miss a great investment.

As promised, this post is short and sweet and here to remind analysts that everything needs to be put in perspective and should be researched in-depth to find out why something is. It keeps us prudent, accountable and robust with knowledge. For those of us that follow the Warren Buffet style of value investing and really enjoy using the D/E ratio; recall that a ratio of 0.8 or less means there is most likely some sort of competitive advantage in the business so start digging and find it.