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What in the world is debt-to-equity ratio?

In spite of what Shakespeare might have led you to believe, debt is a constant of life. And contrary to popular conception, it's not always a bad thing.

Debt in the form of a mortgage allows you to purchase a house before you've reached retirement age, and debt lets you buy a car without throwing $20,000 down all at once. And being able to buy stocks on margin -- which is simply another form of debt -- was what allowed a lot of paper millionaires to become actual millionaires.

Rather than cursing debt, it should be viewed as a positive -- provided it's taken in moderation.

Take a look at corporate America's love affair with leverage. The ability to borrow capital has paved the way for many a mom-and-pop company to grow into a sector leader, yet it has also driven many of the best intentioned corporations into the ground. To ensure that most industry follows the middle road, banks and accountants came up with the notion of the debt-to-equity ratio.

The debt-to-equity ratio is nothing more than a measure of what a company owes vs. the amount of money it has invested in it -- be it from its original owners or investors in the public market -- including any retained earnings. (The denominator can also be referred to as a company's net assets).

The formula's simple enough, but why should this be important to shareholders? Simple: The more outstanding debt a company has, the more its earnings must go to making the payments on this debt load. This in turn will limit the amount of capital that can go to growing the business, research and development, or simply paying good old dividends to shareholders.

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Also, the more debt a company carries, the more the company is effectively owned by its lenders. When a company begins to run into trouble, the friendly banker who encouraged the business to borrow $100 million is quickly replaced by bank envoys who more closely resemble representatives of the Gambino family. No, bank reps don't break knuckles, but they do insist that the company consider its creditors' needs above those of everyone else, including shareholders. In fact, most large banks have "workout" groups whose only purpose is to ensure that debtors who look like they might have trouble making interest payments find the money. To do this, banks use the threat of calling their loans -- thereby causing a domino effect among other lenders and sending the company into bankruptcy -- and thus often can facilitate the sale of core assets or budget reductions that might hamper the company's long-term growth, but will free up cash to pay interest.

Even though lenders will resort to such hardball tactics, they prefer to dole out their money only to companies that should be able to make their interest payments easily. To try to ensure this, banks not only employ the debt-to-equity ratio, but also consider the placement of the new loan in the debt priority structure and the value of the company's physical holdings (which can be liquidated in the event of bankruptcy). Debt has many levels, from senior debt, which will be repaid first in the event of bankruptcy, to subordinated debt, which will be repaid only after the senior loans before it, if at all.

So how much debt is too much when you're looking at a company's balance sheet? It's difficult to say, especially since a number of tricks have been conceived to mask a company's indebtedness -- including delaying executive bonuses until after the quarter's close and repaying short-term debt, then re-borrowing the same amount after the numbers have been fixed on the balance sheet.

While lenders are generally comfortable with a company having a debt-to-equity ratio of as much as 50%, generally, you should set your sites on companies with relatively little, or no debt. Companies with debt less than 20 percent of its long-term capital (that is, long-term debt and equity) should have the best shot at financing long-term growth. Also, newer companies with high debt loads should be analyzed closely, as building up leverage early in a company's life could be a sign of a flawed business plan or inefficient management.

Like gambling, drinking, rich foods and higher education, debt can be useful and positive, so long as it's used in moderation.

-- Posted: Nov. 1, 2000

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