The debt-to-equity ratio is a comparison of a company’s debts (or liabilities) with its equity (assets over liabilities), or rather, with its “net worth”.
When trading and investing, the length of time an investment will take should be taken into account.
For many traders, their time horizon is fairly short-term, from months to weeks to days or even for a few minutes or even seconds.
Most investors, on the other hand, are “in the long run”.
You can be invested in an investment for several months to many years.
Then, how do you evaluate an investment to see if it’s a good time to buy, hold, or sell?
There are two main methods of doing this: technical and fundamental analysis.
Technical analysis Looks at a company’s stock chart, trying to find trends, areas of support and resistance, etc. to determine when to enter (or exit) a trade.
Fundamental analysis instead focuses on the company itself: how it is run (the management team), what type of liabilities it has, what industry it operates in, potential new or future business partnerships or opportunities, etc.
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As you can imagine, the trader who gets in and out of a trade in a matter of minutes is likely to have few concerns about a company’s prospects for the next five to ten years.
Likewise, when the company itself is in debt to its eyeballs and has no predictable outlook and that, an investor with a 10 year time horizon is unlikely to be interested in a company that is a good buy based on a 5 minute chart Half has The management team saves the ship.
Instead of one being “better” than the other, technical and fundamental analysis are partners when it comes to investments.
They have an inverse relationship based on how long you are expected to be in a particular investment / trade.
The longer you expect to be in a trade, the more fundamental analysis outweighs technical analysis.
Conversely, technical analysis outweighs fundamental analysis the shorter you expect to be in a trade.
In this series we will look at some key areas in fundamental analysis.
The first area we will examine is the debt to equity ratio, which is often abbreviated as “D / E” or “D / E ratio”.
Put simply, the D / E ratio is a comparison of a company’s debts (or liabilities) with its equity (assets over liabilities), or rather, with its “net worth”.
This is similar to personal wealth, which is personal “equity” (assets minus liabilities).
However, when evaluating companies, it is difficult to say that Company A with a “Net Worth” of $ 1 million is better or worse than Company B with a “Net Worth” of $ 2 million or Company C with a ” Net Worth “of $ 500,000.
For example, what if I told you that Company A has $ 4 million in debt while Company B and C have $ 3 million and $ 300,000, respectively?
They would need a way to better rate “apples to apples,” as they say. .
Enter the debt to equity ratio.
It’s easy enough to calculate:
Now we can compare companies A, B and C.
We can take the formula and rearrange it to find out a company’s assets by simply adding the numerator and denominator.
Hence, we can see that both Company A and Company B have assets of $ 5 million, while Company C has assets of $ 800,000.
From the examples above, we can see that you cannot simply look at a company’s assets, liabilities, or equity for yourself.
If all three companies were in the same industry, you might never consider Company C because it is less than 1/5 the size of the other two companies.
However, the D / E ratio is clearly the lowest of the three.
This means that it is the least leveraged, which often means that it is able to better weather possible downturns (in the economy, in the industry and / or in the company itself).
However, if it’s an industry with an average D / E ratio of 1.3, a ratio of 0.6 can indicate that leverage is too little.
This could mean much slower growth or a more inefficient use of capital compared to other companies in this industry.
In this case, Company B looks cheaper.
Yes, it’s more than twice as much in debt and ten times the real debt, but it’s closer to what this industry does as a whole.
And while Company A and Company B both have the same fortune at $ 5 million, it’s easy to see that Company B is a better choice as it does almost a third of the leverage.
It’s important to note that the D / E ratio is helpful when comparing companies within the same industryThis does not apply to companies in different industries.
Some industries may be capital intensive and typically have metrics above 1, while less capital intensive industries typically have less than half of that. Other industries like utilities have much higher rates compared to the overall market averages.
However, since they are usually able to maintain a steady stream of income even though they tend to grow more slowly, it usually means an efficient use of capital.
Also, not all liabilities are created equal.
That is, the risks associated with short-term debt, for example, are not the same as the risks associated with long-term debt.
Long-term debt is generally riskier than short-term debt because it is usually more expensive and more prone to changes in interest rates.
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Analysts don’t always classify the same things as debt, either.
For example, one analyst may view preferred stock (which has a preferred dividend, face value, and liquidation rights) as a liability, while another may view a stock as equity.
Also, keep in mind that things like retained earnings / losses, adjustments to pension plans, and intangible assets can skew the relationship.
As a result, more research may be needed before a true one[r] A picture of a company’s liabilities is shown.
You would rightly say that assuming the same definitions were used and the ratios calculated using the same respective numbers, a lower debt-to-equity ratio is generally preferable to a higher one.
While negative numbers are technically “less” than positive numbers, when it comes to the D / E ratio, you should avoid negative numbers.
This means that the company has more liabilities than assets and is often viewed as a very risky sign indicating that there may be a bankruptcy [relatively near] Future.
While there can be many considerations as to what to consider as a debt or liability, or what liabilities to include, the actual calculation of the debt-to-equity ratio is straightforward.
As long as you give the same numbers (or not), you will get a number that can be used to compare companies on a level playing field.
Different industries have different “standards” when it comes to leveraging leverage. Therefore, this metric should only be used to compare companies within the same industry.
While not used as the sole indicator of a company’s value or strength, it is a good indication of the company’s use of leverage.
This can be helpful in determining whether or not a company is making it into an investor’s portfolio.
Disclaimer: The information above applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.