Analysis of Asset Allocation

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Fundamental Analysis: Debt Equity Ratio
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Definition

The debt/equity ratio analyzes the long term liabilities (as defined in the introduction).

You have a lot of items in the long term liabilities like long term debts and shareholder's equity.

Long term debts are an important figures because heavy interest costs can be dangerous for the financial health of the company in the future. Of course if the company can finance its operations and investments through its own earnings, this reduce the cost of the internal funds and therefore reduce the above exposure. But on the other hand, if the company is able, thanks to the loan, to generate much higher earnings than the funding costs, it miss a real growth potential by financing only by own means.

As we have already seen, all is a question of balance.

Based on the above, the debt/equity ratio as been defined as follows:

Debt/Equity = Long Term Debts/shareholders' equity

The higher this ratio is, the more the company is exposed. Like all the other ratios, the value of this one should be compared to his peers and to the industry.

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