The debt to equity ratio is a relatively simple metric to assess the degree of leverage employed by a company. At times, however, this simplicity is a double edged sword. Here’s a simple story to illustrate one of the biggest pitfalls of this ubiquitous metric.

Doctor A bought his clinic (property) 20 years ago for $100,000. He took on no debt and paid everything from his own pocket (equity). As it is used for his medical practice, it is booked under ‘Property, Plant and Equipment’ where it is depreciated to zero over the next 20 years. Assuming there are no other assets or liabilities, and he pays all his profits as dividends such that retained earnings consistently remains at zero. Consequently, the equity of his company is always $100,000. Today, his clinic is worth $1,000,000 on the open market. Because he is a little crazy, he decides to borrow $200,000 ...