The Limitations of the Debt-to-Equity Ratio

Looking Past the Numbers to Understand This Important Investing Metric

The Limitations of the Debt-to-Equity Ratio
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When you're weighing different investment opportunities, a company's debt-to-equity ratio is an important piece of the picture. But it doesn't always tell the whole story.

You've probably heard portfolio managers and famous investors say, "look beyond the accounting numbers and instead focus on economic reality." Let's look at how the debt-to-equity ratio can sometimes distort that reality and make an investment appear much riskier than it is.

The Importance of Debt-to-Equity Ratio for Investors

A company's debt-to-equity ratio represents its total debt compared to total shareholder equity. It illustrates how much a business depends on borrowed money and its ability to repay that money. For investors, at face value, the debt-to-equity ratio illustrates how risky the company is as an investment.

Healthy ratios vary by industry, but the general rule of thumb for investors is this: A higher ratio means a higher risk of bankruptcy in the event of a downturn. For this reason, investors generally favor companies with debt-to-equity ratios at or below the average for their industry. There are a few exceptions to this rule, however.

In most industries, a debt-to-equity ratio higher than 2.0 (2 units of debt for every 1 unit of equity) is considered a red flag.

Share Repurchases and Reduced Equity

One such exception can occur in the event of a stock buyback. Sometimes a company may choose to make its shareholders richer by reducing the total number of shares outstanding. This move eliminates some existing shares, thus increasing each of the remaining stockholders' equity ownership as a percentage of the total business.

If you are a shareholder when a company buys back some stock, your respective portion of the profit and dividends grows even if the underlying enterprise does not. When combined with healthy, cash-generating operating results, share repurchases can result in huge long-term rises in earnings per share.

However, wealth-creating buyback programs can cause a potential investment to appear riskier than it is in reality. The reason: When a company buys back its shares, the result is a reduction in the total stated value of shareholders’ equity. To understand why this occurs, we’ll have to delve into the accounting entries that are recorded each time stock is issued.

A Share Repurchase Example

Imagine that Seattle Enterprises, a fictional company that operates a chain of retail stores, wants to raise $100,000 for a new facility by issuing 5,000 shares of common stock. The shares have a par value of $5 each and will be sold for $20. The accounting entry would appear as follows:

  • Cash debit $100,000
  • Common stock—par credit $25,000
  • Common stock—in excess of par credit $75,000

The corporation raises capital and proceeds are allocated to two lines in the shareholders’ equity statement of the balance sheet. The first $25,000 consists of 5,000 shares issued multiplied by $5 par value per share; the remaining line results from multiplying the excess purchase price ($20 per share minus $5 par value equals $15 excess) by the number of shares issued ($15 times 5,000 shares equals $75,000). The cash ends up in the company coffers and must be debited to the appropriate account ($100,000).

For this illustration, let's also say that the company has debts totaling $100,000, making a debt-to-equity ratio of 1.0 ($100,000 debt divided by $100,000 equity). Now, imagine a few years have passed. Management wants to repurchase $50,000 worth of stock. The transaction is going to look something like this:

  • Treasury stock debit $50,000
  • Cash credit $50,000

Because the shareholders’ equity section normally has a credit balance, the treasury stock (a debit balance) serves to reduce the overall stated value. Assuming the debts haven't changed, now the debt-to-equity ratio is 2.0 ($100,000 debt divided by $50,000 equity).

Should the share repurchases grow large enough, it’s possible that a perfectly healthy, prosperous company could have a negative stated net worth and appear to be 100% leveraged.

Increased Payables as a Percentage of Inventory

There are some cases in which a company's liabilities may be artificially inflated on the balance sheet. Some management teams wisely attempt to reduce the level of assets tied up in working capital—cash on hand and inventory on store shelves, for example. The reason is straightforward: each dollar freed is a dollar that can be used to pay down long-term debt, repurchase shares, or open new stores. At the same time, it is necessary to have sufficient products on the shelf to satisfy demand. Otherwise, potential customers won't waste a trip.

A solution to this dilemma is a form of vendor financing known as pay-on-scan (POS). Under this system, a company does not purchase a product until the customer has paid for it. The vendors, in other words, still own the products sitting on the shelves in stores. In exchange, the stores might give the vendors volume rebates, special placement on shelves, or other incentives.

The result is a drastic reduction in working capital risk and the ability to expand much more rapidly. Why? When a retail company opens new stores, one of the biggest startup costs is the purchase of the initial inventory. Now that the inventory is being provided on a pay-on-scan system, that upfront cost is effectively eliminated. 

The drawback of this method is that the products show up as a short-term liability. Since this represents an increase in debts on the balance sheet, it's going to raise the debt-to-equity ratio. Even though the business doesn't have any additional risk—the product, remember, can be returned to the vendor if it is not sold—some investors and analysts treat this debt as an obligation that could threaten liquidity. This could unneccesarily scare them away.

The Bottom Line

In both of these cases, the on-paper accounting doesn't represent economic reality. The shareholders are better off despite the apparent rise in the debt-to-equity ratio, so they shouldn't let that number scare them. As with so many metrics for analyzing your investment decisions, the debt-to-equity ratio should be examined within the broader context of a company's overall financial picture.