In the complex world of investment, understanding the amount of financial leverage a company bears is crucial. With capital being one of the basic factors of production, companies – especially those facing a dearth of resources – need exogenous funds to finance their corporate expenses, run operations smoothly as well as expand the realm of their business. Among equity and debt – the two most common options used to boost a company’s future earnings – debt is the more popular one. This is perhaps due to the cheap and easy availability of debt over equity financing.

This is because when a company resorts to debt financing, it takes on fixed expenses in the form of interest payments for a specific time period. However, in case of equity financing, a shareholder not only becomes a partial owner of the company but also has a direct claim on the company’s future profits.

Yet, debt financing has its share of drawbacks. The problem arises when leverage, referred to as the amount of debt a company bears, becomes exorbitant. A high degree of financial leverage means high interest payments, which affect the company’s bottom line.

Of course, this does not mean that corporations should totally avoid debt financing. In fact, it has been an inherent instrument for corporations to grow their earnings.

Nevertheless, to be on the safe side, investors try to avoid stocks that bear large debt loads. Empirically, several leverage ratios have been constructed to measure the exact amount of debt risk a company bears in order to safeguard investors from debt traps.

Debt-to-equity ratio is one such measure, perhaps the most popular one, which has been used to evaluate a company’s credit worthiness, for potential equity investments.

Analyzing Debt-to-Equity

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio implies that it has a more or less financially stable business, thereby making it a more worthy investment opportunity.

With the Q3 reporting season drawing to a close, companies recording higher earnings growth will attract investors. However, blindly pursuing high earnings yielding stocks, which have a high debt-to-equity ratio, might drain all your money before you know.

The Winning Strategy

Considering the aforementioned discussion, to ensure safe returns it is wise for investors to choose stocks bearing low debt-to-equity ratio.

However, an investment strategy based solely on debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.

Here are the other parameters:

Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.

Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.

Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.

Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.

Estimated One-Year EPS Growth F(1)/F(0) greater than 5: This shows earnings growth expectation.

Zacks Rank #1 (Strong Buy) or #2 (Buy): No matter whether market conditions are good or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.

Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 17 stocks that made it through the screen.

Big Lots, Inc. (NYSE:BIG): It is a broad-line closeout retailer in the United States. The company offers products under various merchandising categories, which include Food, Consumables, Furniture, Seasonal, Soft Home, Hard Home, and Electronics & Accessories. Currently, Big Lots carries a Zacks Rank #2. It came up with an average positive earnings surprise of 81.10% in the trailing four quarters.

Louisiana-Pacific Corporation (NYSE:LPX): The company manufactures building materials and engineered wood products in the United States, Canada, Chile and Brazil. It carries a Zacks Rank #1 and delivered an average positive earnings surprise of 3.98% in the trailing four quarters.

Diamondback Energy Inc (NASDAQ:FANG): It is an oil and natural gas company focused on the acquisition, development, exploration and exploitation of unconventional, onshore oil and natural gas reserves in the Permian Basin in West Texas. Diamondback pulled off an average positive earnings surprise of 47.35% in the trailing four quarters and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.

Alamo Group, Inc. (NYSE:ALG): It is a leading manufacturer of high quality equipment for right-of-way maintenance and agriculture. The company carries a Zacks Rank #1 and delivered an average positive earnings surprise of 6.12% in the trailing four quarters.

ArcelorMittal SA (NYSE:MT):It is the world’s leading steel and mining company. The company carries a Zacks Rank #3 and delivered an average positive earnings surprise of 43.70% in the trailing four quarters.

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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.

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