V10: Debt-to-equity ratio — how to analyse it

Indebted companies die faster in crises. They cannot pay interest if revenue falls. Low debt = flexibility to invest when competitors struggle.

This is V10 — Debt-to-equity ratio in the AKM1 model: one of the 20 variables that together determine whether a company is an institutional quality stock or a collection of stories. In this article you get the variable explained, how to compute it yourself, and how three of history's greatest investors would have interpreted it.

Why the variable exists

The debt-to-equity ratio as an analytical measure has existed since the early modern stock market. Benjamin Graham and David Dodd introduced systematic debt analysis in 'Security Analysis' (1934), where they emphasised the importance of companies being able to pay the interest rate even in a depression scenario. During the Great Depression (1929-1933) thousands of companies went into bankruptcy because of high debt combined with crashing revenue. After this, 'Graham's margin of safety' — the doctrine that companies should be able to survive a 50% revenue fall without going under — became an investment foundation. The Modigliani-Miller theorem (1958) formalised the theory of capital structure: in a perfect world (without tax, without bankruptcy costs) the debt-to-equity ratio is irrelevant to the company's value.

Debt as a double-edged sword

The nature of debt — why it exists Debt is neither evil nor good — it is a tool. A company borrows money to invest in growth that the company cannot finance with equity. If the return on the investment exceeds the interest cost, debt creates value for the shareholders. If the return falls below the interest cost, debt destroys value. This is the fundamental equation: debt is positive leverage when ROIC > WACC, and negative leverage when ROIC < WACC. The debt-to-equity ratio (D/E) measures how much of the company's capital structure comes from loans vs equity. A company with a debt-to-equity ratio of 100% has as much debt as equity — the company is financed 50/50. A company with a debt-to-equity ratio of 50% has one third debt and two thirds equity. The higher the D/E, the more leverage — and the more risk in crises. 📖 DEFINITION Debt-to-equity ratio (D/E) = Interest-bearing debt (liabilities) / Equity × 100. Measured in per cent.

What counts as interest-bearing debt?

The simple definition — and its flaws The simplest definition is: 'Interest-bearing debt (liabilities) = long-term loans + short-term loans'. You find this in the balance sheet under the headings 'Long-term liabilities' and 'Short-term liabilities'. But this definition is insufficient. It does not capture: 1) IFRS 16 lease commitments — since 2019 companies must capitalise leasing on the balance sheet, which adds large 'liabilities' for retail chains (H&M's store rents), airlines (lease of planes), and logistics companies. 2) Pension liabilities — defined benefit plans create a liability discounted with an interest rate, and should be included. 3) Overdraft credit — unused but constitutes an interest-bearing potential. 4) Hybrid instruments — convertibles, preference stocks. A rigorous analyst adds all of these to get an 'adjusted debt-to-equity ratio' that better reflects true financial risk.

Debt traps and illusions

The net cash illusion A company with net cash (cash > debt) seems to merit score 5 — safe. But it can hide problems. Three traps: 1) The cash is 'locked' — foreign subsidiaries can have cash that cannot be repatriated without tax. Apple had 200+ billion USD abroad before the pre-2017 tax reform and could not use it effectively. 2) The cash is 'earmarked' — the company has received cash from a new share issue to finance a specific investment. PREC after the 2021 issue had high cash, but it was 'burn rate cash' to be consumed. 3) The cash is 'other' — items like 'Accrued revenue' or 'Prepaid costs' can be misclassified as cash by ignorant analysts. True 'free cash' is cash the company can actually use. Always read the notes to the accounts on liquid funds — sometimes there are restrictions.

Three perspectives on the debt-to-equity ratio

Peter Lynch: Lynch avoided companies with a debt-to-equity ratio >100% (more debt than equity). 'Debt is like a flywheel — it amplifies profit in good times and the loss in bad.' He preferred companies with net cash (more cash than debt). Lynch's rule: 'If you must choose between two companies with the same ROE, choose the one with less debt.'

Benjamin Graham: Graham was extremely risk-averse towards debt. His 'defensive investor' rule: debt-to-equity ratio below 50% (debt/equity < 0.5). Graham argued that high debt is the most common cause of bankruptcy: 'Companies do not go into bankruptcy because of poor profits — they go into bankruptcy because of debt they cannot service.'

AK1's interpretation: AKM1 weight 5%. Debt is assessed contextually — banks naturally have high debt (it is their business model), manufacturers low. We adjust for industry: a company with 100% debt in the banking sector is normal, in the tech sector extremely risky. AKM1 combines V10 with V11 (liquidity) and V08 (EBITDA margin) — high debt + low liquidity + low margin = acute risk.

Go deeper

Want to practise with worked examples, chapter by chapter? The course Debt-to-equity ratio (V10) contains 6 chapters, Lynch and Graham perspectives and how AK1 uses the variable in the wave matrix. See also the complete guide to Swedish stock analysis for how all 20 variables fit together.

FAQ

What is the debt-to-equity ratio — and what does it say about a company?

The debt-to-equity ratio (D/E) compares a company's interest-bearing debt (liabilities) with its equity: Interest-bearing debt / Equity × 100. A figure of 100 percent means the company is financed equally by loans and equity. The measure is a fundamental part of fundamental analysis because it shows how much leverage the company carries — and thus how sensitive it is to interest rates and falling revenues.

How do I calculate the debt-to-equity ratio myself?

Open the balance sheet in the annual report and add long-term and short-term interest-bearing debt. Divide the sum by equity and multiply by 100. Remember that a rigorous analysis also adds IFRS 16 lease commitments, pension liabilities and drawn credit facilities — otherwise you underestimate the true debt burden. The course Debt-to-Equity Ratio (V10) walks through the calculation step by step with worked examples.

What counts as a good debt-to-equity ratio?

There is no universal threshold — the industry decides. Benjamin Graham's rule for the defensive investor was a debt-to-equity ratio below 50 percent, while Peter Lynch avoided companies above 100 percent. But for a bank, high debt is part of the business model, while the same level at a technology company is very risky. The AKM1 model therefore always assesses indebtedness in its industry context, combining it with liquidity (V11) and EBITDA margin (V08).

What is the most common mistake when interpreting the debt-to-equity ratio?

The most common mistake is forgetting IFRS 16 lease commitments, which since 2019 appear as liabilities on the balance sheet — retail chains and airlines thus look more indebted than they really are. Another is the net-cash illusion: a large cash pile is not always free to use; it can be locked in foreign subsidiaries or earmarked for a specific investment. Always read the notes to the accounts on liquid funds before drawing conclusions.

This is educational financial analysis, not investment advice.