Just like you wouldn’t date a guy who is up to his eye balls in debt, neither should you invest in a company that has high debt either.
Most companies do need to borrow to expand their business – there is nothing wrong with that, as it helps them grow, but I’m very careful to make sure that they don’t have TOO much debt in relation to their business.
So what is considered too much debt?
I’ve found that a debt to equity ratio of 75 or lower is usually an acceptable level. Anything higher and the company may risk defaulting on its loans if things go sour. Of course just having a high debt to equity ratio doesn’t mean that the company is good or bad – it’s simply that they’ve borrowed a lot of money.
But since I’m a cautious gal I do only choose those companies who have debt to equity ratio’s 75 or less. That means that even if the worst happens and the company did go bust (unlikely if you make sure they also have all the other fundamental rules) then at least they’ll have money left to pay back their debts and that might also include shareholders. If they don’t then it could lead to bankruptcy – something you want to avoid.
Different companies have different levels of debt according to how much they borrow, so it makes sense that a company whose business is say property or machinery would have higher loans that a company who is more service oriented.
And then of course you have banks and other financial institutions that don’t have any debt at all (since they are the ones LENDING the money, not borrowing it).
Usually you’ll notice that if a company has been aggressively borrowing to finance a new project or more stock that their earnings will (or should) grow the following quarter.
You can either work out the debt to equity ratio yourself by dividing shareholders equity from the total liabilities of the company, but of course you don’t have to because it’s already calculated for you.
You can find the debt equity ratio for the companies that you are interested in investing in on their Key Statistics page.
Here is the debt equity ratio for Boeing showing a high debt equity ratio of 291.71. Too high for the rules but completely understandable because aircraft are expensive last time I checked.
If you are curious, the mrq stands for most recent quarter, so this number is updated each time (usually quarterly) the company releases its financials.
A Debt to Equity ratio of under 75 was the third rule in the 5 Simple Rules for Investing in the Stock Market. I’ve already talked briefly about the first two, Return on Equity and Increasing Earnings so I’ll talk about the final two in the next few blog posts.
I hope this helps you choose strong companies with strong fundamentals so you can make some money in the stock market.