There is no better way to ascertain the financial health of any company than studying its balance sheets. One of the important financial parameters which needs to be considered in such a study, is the long term debt-to-equity ratio. It determines the amount of debt liabilities of any company.
Every business has a certain amount of debt which it acquires through loans, to finance its business initiatives and projects. However, every new acquired debt comes with a substantial amount of risk and financial burden, while also providing an opportunity to expand, grow, and acquire new assets. As long as the borrowed money is well invested and generates sizable returns, the debt burden is not that difficult to carry, but when the profit margins dry out, debt burdens can crush and bring a company to bankruptcy.
There are many ratios which are defined to evaluate the financial health of any business. In the simplest words, debt-to-equity ratio is the value obtained, when the amount of liabilities of a company, are divided by the total equity holding of shareholders. When only long-term debts are included as liabilities, the calculated parameter is called long-term debt-to-equity ratio.
As simple arithmetic will reveal, larger the accrued debt of a company, higher is the ratio going to be. All debts come at a cost, which is the interest rate charged on the principal amount of borrowing and they eat into the profit margins of a company. So, unless a fresh cash infusion through a mortgage loan is going to add to the profit margins of a company, it's a bad business decision overall. Still, risks need to be taken and certain investments take time to bear fruit. In such cases, a company may risk a high debt-to-equity ratio, with the hope of making profits in the long term.
To be able to calculate the ratio, you need to have access to some crucial financial data, that includes the long-term debts of the company, along with the valuation of the shareholder's equity holding. The formula is as follows:
Long Term Debt-to-equity Ratio = (Total Long Term Debts/Shareholder's Equity Value)
As mentioned before, you only consider long-term debts like mortgage loans on land and other assets, while making this calculation. A low ratio value means that the company is in relatively good shape, with assets that can keep it buoyant with manageable debt. A very high ratio value means that the company has borrowed heavily and is in a risky financial position, unless bailed out by good performance overall and good quarterly profit margins.
A high value of this ratio is bad news for a company as it cuts into the profits and weighs heavily on the overall finances. On the other hand, a low debt-to-equity ratio indicates that the company is in overall good health and is a comparatively better stock investment option, as debts are not cutting into its profits to a large extent.