For a business, using debt can be a bit like putting your foot down on the accelerator. The chances are that you'll get to where you want to go a little faster but if something goes wrong, the consequences are more likely to be serious. Since we have an unusually strong aversion to losing money, we tend to steer clear of most debt-laden companies (we'd rather you call us prudes than punters). But debt can have a place. It's just that you won't hear us complaining about a company's balance sheet being 'undergeared', as some in the press so eloquently describe debt-free businesses.

From a company's point of view, borrowing is often the cheapest source of financing. But, like most things in life, you can have too much of a good thing. Assessing debt levels, therefore, is a very important part of the analysis of a company and its stock. So how do you work out whether debt levels are too high? Over the next two issues, we're going to look at the two main financial ratios that we use in the analysis of a company's debt position to answer that very question.

Net debt-to-equity ratio

This is a measure of total net debt compared to shareholders' equity. All the figures used to calculate this ratio can be found in the balance sheet of the company's annual report but, before we get into the nitty-gritty, let's look at what net debt-to-equity actually means. It is, in effect, a measure of how the company's assets are funded and it's calculated by expressing, as a percentage, debt funding versus equity capital. Let's say you recently bought a house for a fair price of $300,000. You borrowed $200,000 and kicked in $100,000 of your own money. You also own other assets with a fair value of $50,000 and no other debt. In this instance, your total assets add up to $350,000. Of this, the bank effectively owns $200,000 while you own outright $150,000. So your equity is $150,000 and your net debt-to-equity ratio is 133% ($200,000/$150,000).

Now this figure can be manipulated up and down. For instance, if you admit that the Jaguar in the driveway is really only worth $30,000 rather than $50,000, net debt-to-equity jumps to 153% ($200,000/$130,000). And if you 'revalue' the house from $300,000 to $350,000 due to a booming property market, the ratio drops to 100% ($200,000/$200,000).

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