How to Explain Debt-to-Equity Ratios

Explain debt-to-equity ratios by focusing on their relationship.

Stocks and bonds are the two most popular investment vehicles for both individual and institutional investors. Stocks and bonds are the debt and equity that companies issue to raise capital for the company. From the company's perspective, issuing debt has different consequences from issuing equity. In explaining debt-to-equity ratios, it is important to note this relationship, what it means for the investor's return potential and what it does to the company's balance sheet.

Instructions

1. Show how companies acquire debt by reviewing the sources and types of debt available. The most common types of debt are bank loans and bonds. The higher the loans and the more bonds a company issues, the higher the debt load.

2. Walk through the relationship between stock issuance and equity on the balance sheet. In general, as the company issues more stock, the amount of stockholers' equity increases. Market capitalization, which is the product of the current price and the number of shares outstanding, is a good way to show this.

3. Illustrate the primary difference between equity and debt for the company in terms of issuance. Companies have to pay back debt, but they are not required to pay back equity. Stocks are considered ownership in the company.

4. Create a presentation comparing debt-to-equity ratios against different companies in the same industry.

5. Use the presentation to explain how to interpret a high or low debt-to-equity ratio. In general, a high debt-to-equity ratio signifies the company is financed with a greater degree of debt and may be more illiquid than other companies in the same industry. Companies with lower debt-to-equity are financed with more equity than debt and are generally considered to be better investments.

References

• Value Based Management: Debt to Equity Ratio