Why Debt-Equity Ratios Matter to Growth Investors

Debt plays an important role in analyzing the profitability and performance of a publicly held company. Although a certain degree of debt is not necessarily a bad thing, companies that rely on debt for their daily operations place themselves in a vulnerable situation, opening up the possibilities of bankruptcy. Due to this, analysts and growth investors use the debt- equity ratio of a company to gain insight into its solvency and financial condition.

Debt- Equity Ratio Explained

The debt- equity ratio essentially measures how reliant a company is on debt. To calculate the ratio, investors simply divide the total debt of a company by the total amount of shareholder equity. To gain a truly accurate depiction of the true total debt held by a company, any off of the balance sheet liabilities, such as health benefits and employee pensions, as well as any interest- bearing leases that can be found in the footnotes of a financial statement should also be taken into consideration.

According to www.smallbusiness. wa. gov, the higher the debt- equity ratio, the more reliant on debt a company is to finance its operations, which increase risk to lenders. A 1: 1 debt- equity ratio indicates that the shareholders and the lenders bear the same amount of risk.


The debt- equity ratio of a company says quite a lot about its risk level. Companies with high debt levels are usually leveraged to the hilt, and may provide investors with larger returns. However, high debt levels also leads to a higher amount of interest that must be paid on loans, creating possible financial difficulties.

Typically, conservative growth investors, such as Warren Buffet, prefer companies with lower debt levels. The return on equity may not be as great, but the company may be more stable and have increased access to debt and equity markets for future growth and expansion.

Risks Associated with High Debt Levels

High debt levels can significantly cut into the profits of a company. Unlike equity, which is only paid out when a company reaches profitability, debt financers demand consistent payments with defined interest rates. Therefore, high debt levels can cause a company to devote a substantial amount of potential profits to paying interest on their debts. Without the debt, the money can go towards shareholder dividend payments or company expansion.

It is difficult to ascertain the exact level of returns that are needed to spur shareholder investment. There are several models that investors use to estimate this amount, but most of these models use a combination of the risk and returns of similar companies and interest rates. In most cases, in order to justify investment, the level of return must be higher than the company’s debt interest rates.

Access to Capital Markets

Disproportionately high debt levels can increase the difficulty of receiving new business loans or attracting new investors. In the eyes of lenders, extremely high debt levels increase the risk of default on future loans, making them less likely to approve new loans and more likely to raise interest rates on existing loans. Similarly, the increased risk associated with high debt levels often requires potential investors to seek higher returns.

Expert Insight to Growth Investing

Successful buy- and- hold growth investors, such as Warren Buffet, encourage the notion of avoiding companies with high debt levels. Buffet and many others understand that leverage can increase a company’s return on equity, but due to the potential long- term consequences of high debt levels, they recommend putting their investment dollars into companies with low debt- equity ratios and strong balance sheets. While some investors take the opposite approach, seeking higher potential profits.

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