Investing in shares: The importance of the debt to equity ratio 

This is part of an ongoing series of articles aimed at retail investors thinking of investing in shares. The series explores the potential warning signs that investors should look out for before investing in a company.  

This article focuses specifically on the significance of the debt to equity ratio: what is it, why is it so important and what impact does it have on a company’s share price performance.  

The debt to equity ratio calculation will be explained using a case study and will rely on the financial statements of Nostrum Oil and Gas Plc (LON: NOG) which is listed on the London Stock Exchange. 

At this stage, it is worth pointing out that the debt to equity ratio is also known as the leverage ratio or the gearing ratio; and while the terms are used interchangeably, each one explains the same concept. 

What is the debt to equity ratio and how is it calculated?

Arguably, the easiest way to explain the debt to equity ratio is to consider the financial situation of someone buying a property.  

Let’s say the purchase price of the property is £200k; the buyer has a deposit of £40k (from savings); and has managed to secure a mortgage of £160k for the balance of the purchase price.  

The equity in this scenario is the £40k (or 20% of the purchase price) and the debt is £160k (80% of the purchase price). Therefore, in simple terms the debt to equity ratio is 80:20. 

Another way of looking at this is to say that the debt amount is four times greater than the equity (160/40). So, the ratio can be expressed as 4x.

The same principle applies to understanding and calculating the debt to equity ratio of a company and the Nostrum case study below will illustrate this. 

Why is the leverage ratio so important?

Companies can raise capital to fund their operations using a combination or debt finance and equity finance.  

Debt can include anything from bank term loans to convertible loan notes and corporate bonds.  

Equity in this case is share capital issued to investors, plus any profits earned by the company that have been retained and re-invested back into the company (after paying tax and dividends). Equity is also known as shareholder funds. 

Striking the right balance between debt and equity will have an impact on company performance and shareholder returns and the leverage ratio is a very useful way of measuring this. 

Too much debt and the company is deemed to be highly geared and therefore considered a higher risk investment proposition. Too much equity and the shareholders may not generate the level of return they would like, especially when the cost of borrowing is low. 

Debt to equity ratio: Case study Nostrum Oil and Gas Plc

Nostrum Oil and Gas very helpfully provide a schedule of financial metrics showing the total debt and equity figures which allow the leverage ratio be calculated. All figures are in USD million, unless otherwise stated. 

You will note from the table below that the leverage ratio has moved from 1.0x (or 100%) as at 31st December 2014 to 2.0x (200%) as at 31st December 2018. During the same time frame, its share price has fallen sharply from £6.27 to £1.38. As at 1st August 2023 Nostrum’s share price is trading at 11.5p.

While the increase in level of gearing clearly illustrates the negative impact on share price, there may of course be other factors at play. For example, you will note the level of oil production has fallen over the same period and the price of oil will also be a contributing factor. 

Nostrum Oil and Gas
Debt to equity ratio
Five-year financial summary
			Dec-14	Dec-15	Dec-16	Dec-17	Dec-18
Production (BOEPD)			44,400	40,391	40,351	39,199	31,254
EBITDA			494.7	229.4	194.3	232.0	231.3
Net Cashflow operating activities			349.1	153.3	206.5	182.6	214.0
Cash & Cash Equivalents			400.4	165.6	101.1	127.0	121.8
Total Debt			945.1	951.5	959.0	1,087.9	1,129.6
Net Debt			544.7	785.9	857.9	960.9	1,007.8
Equity			917.7	773.8	692.0	669.6	557.0
Debt to Equity Ratio			1.0	1.2	1.4	1.6	2.0
NET Debt to EBITDA			1.1	3.4	4.4	4.1	4.4
Share Price (in pence)			627.0	275.0	471.0	311.0	138.0

What are the potential implications of too much debt?

Obviously, the borrower needs to service its debts (being the amount of interest payable). The payments needed to do so will be funded through operating cashflow; plus at some point the actual debt itself needs to be repaid either from surplus cashflow or through asset disposals.  

In the meantime, while the borrower is prioritising payment of debt, shareholders may not receive the dividends they were expecting or any dividends for that matter. Also, as we can see from the Nostrum case study, the higher the level of gearing, the greater the potential decline in the share price of the company. 

Another concern with leverage is that banks (or other lenders) only ever advance money with conditions attached. These conditions are known as covenants and can be multifarious and also provide a fairly stringent framework within which the borrower can operate their business.   

For example, the lender might state within its loan terms that where a company’s earnings (EBITDA) or its net assets fall below certain levels agreed with the lender, then the borrower could be in breach of the loan covenants.  

In effect, where a company is carrying too much debt which results in a breach, this should trigger major concern for investors and questions will need to be asked: 

1. Can the company negotiate a waiver on the lending covenants and at what cost? 
2. Can the company trade its way out of the problem and if so, how? 
3. Will the company need to go to its shareholders requesting additional capital? Rights issues tend to be raised at a discount to the  prevailing share price.
4. Will the dividend distribution be delayed or cancelled? 
5. In a worst-case scenario, if the company cannot remedy the breach, will the lender call in the loan? 

Further articles in the series: Investing in Shares

While I have covered the impact of the leverage ratio in some detail here, there are other warning signs that investors should be alert to before investing in shares. You can read about these by clicking here.