Buying Stocks (value investing) using financial ratio : Debt Analysis

Thursday, March 3, 2011

Debt-Equity Ratio  & Debt Ratio :
The debt-equity ratio provides company's leverage position by comparing total liabilities to shareholders' equity where as debt-ratio compares a company's total debt to its total assets,. A lower percentage means that a company is using less leverage and has a stronger equity position.


The debt-equity ratio is one of the most frequently used term in investment literature. This simple ratio provides a general indication of a company's equity-liability relationship and is helpful to investors looking for a quick take on a company's leverage. Generally, large, well-established companies can push the liability component of their balance sheet structure to higher percentages without getting into trouble.

The debt-equity ratio percentage can give  dramatic perspective on a company's leverage position than the debt ratio percentage. For example, Company A's debt ratio of 70% seems less onerous than its debt-equity ratio of 210%, which means that creditors have more than twice as much money in the company than equity holders. 
If the company manages to generate returns above their cost of capital, investors will benefit. However company can be easily hurt by this leverage if it is unable to generate returns above the cost of capital. Basically, any gains or losses are magnified by the use of leverage in the company's capital structure as leverage is a two edge sword.
Capitalization Ratio :

This ratio measures the debt component of a company's capital structure.

Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios.

There is no right amount of debt. Leverage varies according to industries, line of business and its stage of development. However low debt and high equity levels in the capitalization ratio indicate investment quality.

Company's capitalization (not the market capitalization which equals No of free-float share multiplied by share price) is used to describe the composition of a company's long-term capital, which consists of both long-term debt and shareholders' equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of good financial health.

A highly leveraged company(high percentage of debt in caitalization) may find :

a) freedom of action restricted by its creditors 
b) have its profitability hurt by high interest costs 
c) Worst of all scenarios is having trouble meeting operating and debt               liabilities on time 



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