When you analyze a stock, it’s important to have an idea of how likely it is to survive a business slump and go on to prosper when economic growth resumes.

A number of factors can help you to do that. These include the interest rate on the company’s debt, how sensitive it is to economic cycles, its advantages and disadvantages in relation to competitors and so on. (These are just a few of the factors we take into account in our stock market research when we manage the portfolios of our Successful Investor Wealth Management clients.)

Many successful investors start their stock market research on a company by looking at its debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.

Focusing your stock market research on debt to equity can give a misleading picture of a company’s outlook

A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.

Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course).

But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by cutting them or “taking a writedown.”

How Successful Investors Get RICH Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor. How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

The company’s real value may also be in its “goodwill” — its brand, or the reputation and relationship it has built up with customers over the years. This value would only appear on the balance sheet if it was acquired rather than built up by the company’s operations.

Look to debt to market cap instead of debt to equity

Instead of debt to equity, we recommend that you look at the ratio between a company’s debt and its market capitalization or “market cap” (the value of all shares the company has outstanding) in your stock market research.

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

Still, it’s just a starting point. Interest rates have come way down. That cuts interest costs for creditworthy borrowers. But lenders continue to be picky about who they take on as a borrower. That makes it hard, if not impossible, for companies with bad credit to borrow or refinance existing loans at attractive rates.

If you’d like me to personally apply my value-investing approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.