The Relationship Between Debt & Equity

When looking at prospective investments, possibly the most important thing to look at is debt. Not just debt, but the firm's ability to carry the debt. This is central in any investment decision. The relationship between debt and equity is the formal means of understanding this carrying capacity and ultimately, the financial health of the firm.

Formally, the relationship between debt and equity is a ratio that measures the amount of debt versus the amount of equity owned by shareholders. Simply put, it is a ratio between the amount owed to creditors of all kinds and the amount of capital owned by shareholders, or the amount of capital under the ownership of the firm. Even simpler, it is the amount owed versus what the firm actually has, including cash flow.

For investors, the debt to equity ratio is about the financial health of the firm and the nature of its own investment policy. Taken in isolation, a firm that has high debt versus its capital possessions seems to be in trouble or poorly managed. Shareholders might worry that high debt might make it difficult or impossible for the firm to pay what it owes and satisfy shareholders in the event of dissolution.

Debt versus equity should not, however, be taken in isolation. Debt financing is cheaper than equity, or selling shares, and therefore, high debt might mean an aggressive strategy that will pay off in the end. This is especially true among firms with a high cash flow. If cash flow is high, then even a firm with much debt versus equity is not in trouble, but is expanding quickly and financing new projects with loans versus selling shares. On the other hand, high equity might mean the firm is sluggish, not using its equity to finance new products or expansion.

Investors who do not like surprises want to invest in firms with low debt to equity ratios. Low ratios here are generally conservative firms with low volatility. One mark of high debt is that earnings will likely be volatile and risk is higher. For investors, another ratio that can supplement debt to equity is income to interest. These two ratios taken together tell more of the story since cash flow can be used to control for high debt.

The debt-to-equity ration is a good way to determine the health of a firm and its general policies, but it must be taken in context. Capital-intensive firms like those in the automotive or petroleum industries almost always have high debt due to expensive equipment. The big issue here is general cash flow rather than the ratio. Debt means little if the firm is growing and earning at a healthy rate. Debt means everything if the cash flow cannot keep up with obligations or is receding relative to debt.