Debt-to-Equity Ratio

The nature of debt — why it exists

Debt is neither bad nor good — it is a tool. A company borrows money to invest in growth it cannot finance with equity. If the return on the investment exceeds the interest cost, debt creates value for shareholders. If the return is 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 liabilities (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 / Equity × 100. Measured in percent. AKM1: p1 = >150% (very high), p2 = 100-150% (high), p3 = 50-100% (normal), p4 = 20-50% (low), p5 = <20% or net cash.

Why stability is an AKM1 category

AKM1 has five categories: Valuation, Growth, Profitability, Stability, Moat. Stability is the category that answers the question: 'can the company survive a crisis?'. A company can have fantastic growth, profitability, and valuation — but if it has high debt, low liquidity, and volatile cash flow, it can go under in the next recession. Stability is insurance against catastrophe. The debt-to-equity ratio is the first of three stability variables because it measures the biggest risk: the interest burden. A company with a debt-to-equity ratio of 200% may pay 8% of revenue in interest rate costs — if revenue falls 30%, the interest can exceed gross profit and the company goes bankrupt. A debt-to-equity ratio >150% has historically been the strongest single predictor of bankruptcy among industrial companies.

💡 INSIGHT

A debt-to-equity ratio >150% has historically been the strongest single predictor of bankruptcy among industrial companies. High debt = higher interest cost = higher break-even revenue = less margin for error.

Industry-dependent — not one size for all

The debt-to-equity ratio is always interpreted in industry context. Banks' D/E is normally 8-12x (they have deposits as 'debt' but these are interest-bearing and constitute their business model). Property companies typically have 50-70% debt-to-equity ratio (properties are collateral, long-term operations). Industrial companies should have <50% (cyclical, need a buffer). SaaS companies should have <20% or net cash (low capital base, scalability). Comparing Swedbank (D/E ~10x) with Atlas Copco (D/E ~30%) is meaningless — they have different business models. Industry comparison is the only reasonable interpretation. The AKM1 score is based on these industry reference values: a property company with 60% D/E gets score 4, an industrial company with 60% D/E gets score 3.

⚡ KEY INSIGHTS Debt is positive leverage when ROIC > WACC, negative when ROIC < WACC D/E >150% is the strongest single bankruptcy predictor for industrial companies Industry context is decisive — banks 10x, property 50-70%, industry <50%, SaaS <20% Stability in AKM1 = 'can the company survive a crisis?' — debt is the first risk 2

The simple definition — and its shortcomings

⚠️ WARNING

IFRS 16 — the leasing revolution of 2019

📖 DEFINITION

IFRS 16 (applicable from 1 Jan 2019) requires capitalization of all lease agreements >12 months on the balance sheet as an interest-bearing debt. Effect: retail, aviation, logistics got 'higher debt' without business risk changing.

Pension liabilities — the Swedish special case

Sweden has a long tradition of defined benefit plans (DB pensions), especially among older industrial companies (Volvo, Atlas Copco, SKF, Sandvik) and state-owned companies. These create a pension liability on the balance sheet discounted with an interest rate. Two problems arise: 1) The discount rate is often low (3-4%), which makes the liability large — when the interest rate falls, the liability increases in accounting terms. 2) The liability can grow if the return on the pension assets falls below the assumption. A company with 5 billion in pension liability and 2 billion in equity has a hidden debt-to-equity ratio that is much higher than the reported one. Atlas Copco and SKF have historically had significant pension liabilities — always read the note on 'Pension commitments' to understand the true size. Modern companies have moved to defined contribution plans (DC), where the company only pays a premium and no liability arises. SaaS companies and startups typically have no pension liabilities.