Debt Equity Ratio: Too Much Debt is Toxic!

Alright let’s explore the Debt Equity Ratio (DER) in more detail to find out what it is and what it tells you.

As mentioned previously, this ratio shows how much debt a company has on its balance sheet as a percentage of its shareholder’s equity.

Here's how to calculate it:

DER = TOTAL LIABILITIES/SHAREHOLDERS EQUITY

It shows how much debt the company is using to finance its growth.

Let’s look at an example...

XYZ Financial has been in business since 1927. Its total liabilities are $64 billion and its shareholder`s equity totals $160 billion.

So XYZ`s DER would be..... $64 Billion/$160 Billion = 0.4 or 40%

Looks like XYZ is conservative with debt... good sign!

A company can increase earnings faster by using debt but too much is dangerous when times get tough (and they will!). When the economy slows down and/or interest rates rise on borrowing costs, the company must still be able to cover the interest payments.

If earnings fall, the interest payments will eat into the profits. The same situation occurs when interest rates increase. If both occur at the same time....ouch!

This could make for volatile earnings - something dividend growth investors don`t like at all.

You want to make sure the companies you invest in can withstand any storm that may come up. Companies with low debt and plenty of cash have the means to ride out bad times. Especially when the products they sell are needed regardless of whether the economy is up or down.

Later on you`ll learn exactly what our benchmarks are for selecting the best dividend paying stocks. For now let`s focus on building a solid base of knowledge. In due time my friend!

Ok now that you have a grasp on the DER, let`s move on to the Dividend Payout Ratio.

Return from Debt Equity Ratio to Evaluating a Dividend Paying Stock

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