# Debt/Equity Levels



## Ariyahn2011 (23 December 2014)

Hi guys,

Just trying to learn how a company has low debt? 

Is the debt/equity a good indicator? Just trying to work out the best way to know much debt they have compared to their assets/revenue. 

Thanks in advance for any advise.


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## luutzu (24 December 2014)

Ariyahn2011 said:


> Hi guys,
> 
> Just trying to learn how a company has low debt?
> 
> ...




Assets = Debt + Equity

So debt ratio = debt/assets; and debt/equity... kinda measure the same thing, just give different perspective of debt in relation to all assets or relative to equity.

Maybe break down Equity further into Retained Earnings and Contributed Equity.

You'd want one with higher retained earnings than ones with more contributed Eq (raising more cash from owners)...

So look at that ratio too and not just the debt ratio.


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## galumay (24 December 2014)

just be careful of companies reporting net debt versus gross debt, also income coverage ration is an important metric, a company can have a high level of debt but because of the terms of the debt and cash flow the business has no problem servicing that debt, another company with a low debt ratio can be a marginal operation because it doesnt have the ability to continue to service debt in an earnings downturn.

I usually look for an income coverage ratio of greater than 4, and a debt ratio of under 50% as a primary screen.


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## Ariyahn2011 (25 December 2014)

galumay said:


> just be careful of companies reporting net debt versus gross debt, also income coverage ration is an important metric, a company can have a high level of debt but because of the terms of the debt and cash flow the business has no problem servicing that debt, another company with a low debt ratio can be a marginal operation because it doesnt have the ability to continue to service debt in an earnings downturn.
> 
> I usually look for an income coverage ratio of greater than 4, and a debt ratio of under 50% as a primary screen.




Thanks for the responses guys. 

I am still a bit confused as to how to best determine the debt level? Is there a formula I can follow which is easy to use? At the moment I use the debt/equity ratio as it gives me a decent idea. I kind of dont understand the balance sheet when they have long term debt etc etc. Wondering if there is an effective way to easily determine their equity / assets vs debt. 

Thanks in advance


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## luutzu (26 December 2014)

Ariyahn2011 said:


> Thanks for the responses guys.
> 
> I am still a bit confused as to how to best determine the debt level? Is there a formula I can follow which is easy to use? At the moment I use the debt/equity ratio as it gives me a decent idea. I kind of dont understand the balance sheet when they have long term debt etc etc. Wondering if there is an effective way to easily determine their equity / assets vs debt.
> 
> Thanks in advance




What do you want to know from the amount of debt level?

Assets are things (can't remember a better word now) that a company controls. What a company controls are what the shareholders/owners have put into it (equity) and what liabilities/debt it has incurred/borrowed. That is, A = L + E.

Ideally you'd want to buy into a company that has little or no debt. For a few reason: less debt mean you own more of the company (higher Eq.); less debt mean less chance of default and going bankrupt, less risk in terms of interest rate rise etc... and also, less debt mean greater potential ability to borrow when times are tough or when they find a good investment opportunity... 

If a company have too much debt and its operations/earnings cannot cover interests repayment or can't stand tough times too well... what it will mean is it will most likely raises more cash from you and other owners... ie. your ownership will be diluted.

So what's a good level? Like Gulamay said, best not to be more than equity... but then if the company can't borrow so have to raise new equity, thus lowering its debt/equity ratio, it might still be bad. 

So know the context and how it works and relates... a simple figure tend not to tell you much.


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## Ariyahn2011 (26 December 2014)

luutzu said:


> What do you want to know from the amount of debt level?
> 
> Assets are things (can't remember a better word now) that a company controls. What a company controls are what the shareholders/owners have put into it (equity) and what liabilities/debt it has incurred/borrowed. That is, A = L + E.
> 
> ...




I see. I did read that in Benjamin Grahams book, that low debt is better.  So basically what is the best way to work it out? a company with 10-40% Debt/Equitity level okay? 
Or do i need to add total equitiy - total liabilities to get an idea of their debt level? Sorry if I am asking the same question. Still not sure quite sure how to exactly work out how much debt they have vs equity. 
Cheers!


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## luutzu (26 December 2014)

Ariyahn2011 said:


> I see. I did read that in Benjamin Grahams book, that low debt is better.  So basically what is the best way to work it out? a company with 10-40% Debt/Equitity level okay?
> Or do i need to add total equitiy - total liabilities to get an idea of their debt level? Sorry if I am asking the same question. Still not sure quite sure how to exactly work out how much debt they have vs equity.
> Cheers!




Say you start a business and put in $100. That's your equity.

If you borrow (or owe supplier/customers/employees etc.)... this is a liability. 

So say you owe $50... this mean your total assets (economic resources you control) is A= L + E = $50 + $100 = $150.


Dividing liability to total assets or to equity just give you different perspective: 

L/TA = $50/$150 = 33%
L/E = $50/100 = 50%

So in relation to all assets the company controls, debt (liabilities) is 33%... in relation to owners Eq. it's half.

So maybe just use both.

Best way to interpret is to look at the business and its context. You probably could be OK with a higher debt ratio if assets are liquid or tangible or could fetch a good or higher price if sold now then what it is on book... But you'd probably want a low debt ratio if most of the assets are intangibles and women's fashion or something.


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