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Businesses need money to grow. To get money, companies must either borrow money or sell shares of equity to investors, or some combination of the 2 strategies.
Striking the right balance between debt and equity is one of the great arts of corporate finance, says Keith Lanton, president of Lantern Investments in Melville, New York.
"The goal as business owner is to maximize the leverage and get the greatest return on equity without ever having an event that would jeopardize the business," he says.
To understand the capital structure of a business, investors look at the company's balance sheet. It lists the company's assets, liabilities and equity.
The relationship between total debt and total equity is called the debt-to-equity ratio.
Total liabilities / total shareholder equity
The higher the ratio, the more a company relies on debt to finance operations.
Not all investors want the same ratio
Investors sometimes like more debt in order to get a better return on their money. But that's not always the case. It depends on the investor.
"We're conservative value investors, so that means that balance sheets matter a whole lot to us," says Eric Wightman, managing director of The Wise Investor Group at Robert W. Baird & Co.
"Though we can't hang our hat on just one metric, all things equal we prefer a company has no debt because all the free cash flow can go to shareholders, buy back shares or pay dividends," he says.
With no debt, there's no risk that the company will stumble into bankruptcy, leaving shareholders holding the bag.
The flipside is that debt can boost returns to shareholders.
"The impact leverage has on equity holders is tremendous," Lanton says.
Microsoft's debt-to-equity ratio rose over 4 years
|Total shareholders' equity||$80,083||$89,784||$78,944||$66,363|
|Debt to equity ratio||1.201||0.920||0.804||0.827|
How else do investors use the debt-to-equity ratio?
Like other ratios, the debt-to-equity ratio is mostly useful for comparison purposes.
"An investor would want to compare the ratios of a single firm over time for trend analysis, as well as compare the firm's ratios to an industry average in cross-section analysis," says Robert R. Johnson, Ph.D., CFA, president and CEO of The American College of Financial Services.
To understand the capital structure of the business, investors need some context. For instance, they need to know how much debt is usual for specific industries and similar businesses.
Capital intensive industries and those with very dependable income may have more debt, for example.
"Electric utilities require large investments in plant and equipment and have higher debt-to-equity ratios than technology software companies that don't require such extensive investments," Johnson says.
As of January 2016, the shoe industry has the lowest debt-to-equity at 2.95%, not adjusted for leases. Adjusting for the liability of leases, the software industry has the lowest at 4.43%, followed by shoes at 6.79%. The financial services industry sports the highest debt-to-equity ratios. For example, banks have an industry average of 216.41%, adjusted for leases, according to the online database compiled by Aswath Damodaran, a professor of finance and valuation at the Stern School of Business at New York University.
While the debt-to-equity ratio is a key measure for investors, it's just one of many pieces required for the full picture of how well a company works.