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One Metric You Need to Know Before Investing

By Motley Fool Staff – Dec 25, 2015 at 8:42AM

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It's all about the debt-to-equity ratio (and how to calculate it).

The debt to equity ratio, which can be calculated from a company's balance sheet, tells investors how much a company is financing assets with debt relative to their equity.

In this clip, Motley Fool healthcare specialists Kristine Harjes and Todd Campbell explain what the number means in terms of resource allocation and growth, where to find it, how to calculate it, how it normalizes for company size differences in a way that pure numbers can't, what range to look for in sound investments, and two real-world examples from the healthcare sector.

A full transcript follows the video.

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Kristine Harjes: Next ratio that we wanted to talk about is debt to equity. This one basically tells you how much debt is being used to finance your assets relative to your equity.

Todd Campbell: Right. One of the things that's very important to figure out is, where is money coming from, and is that money being used well? Is it helping to grow the company, or not? And one of the things that I like to consider is the debt to equity ratio. There are various ratios that you can look at, debt to assets, etc. I happen to prefer the debt to equity ratio because it's telling me how much of the money is being financed by loans, and how much is being financed by investors.

Again, if you have a debt to equity ratio that's above 100%, it makes you wonder a little bit, because you're saying, "Okay, there's a lot of debt on the books here relative to how much money has come from investors, via retained earnings or the stock offering initially." So, in the case of these two companies, what you want to find is, you want to find a debt to equity ratio that is below 100%. Lower is typically better than higher. And again, since both of these are very big companies, you shouldn't fault them for having some debt. Again, somewhere between 0 and 100% is great. And Kristine, would you do the honors and tell us what those number are?

Harjes: I'd love to. Pfizer (PFE -0.76%) clocks in at 58.18%, and BMY comes in at 47.69%. So, that's right in that sweet spot that you were talking about. And the advantage, again, goes to Bristol-Myers Squibb (BMY -1.15%) .

Campbell: Yeah. Bristol-Myers edges out Pfizer on this metric, again. So, we now have it edging out Pfizer on the current ratio, and we now have it edging out on the debt to equity ratio. Now, there's another point, another take away is that I want to make. The reason that we're using ratios rather than absolute numbers -- you could look at it and say, "Wow, Pfizer has more total cash on the books than Bristol-Myers." Or, you could say, "Pfizer has more total debt on the books than Bristol-Myers." But you've got to recognize, too, that these two companies are different sizes. So, you got to normalize that, and ratios allow you to do that.

Harjes: Right, Pfizer is almost double the size of Bristol.

Campbell: Yeah. So, you can't just say, Pfizer's got X billions of dollars more on the books than Bristol, and have that really tell you whether or not one is financially healthier than the other.

Kristine Harjes has no position in any stocks mentioned. Todd Campbell has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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