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Going Back to Fundamentals (3): Debt to Equity
Posted by: David Chulak (IP Logged)
Date: June 14, 2012 10:48AM
In what might be considered by some as the simplest of criteria to evaluate, I have found that the debt to equity ratio actually can be very difficult or at best, time consuming. Why? Because once again, it’s just a number, and it means nothing unless you compare it with peers in the same industry and delve deeper into some hidden meanings behind the number. Let me explain.
The Debt/Equity ratio is simply:
Total Liabilities/Shareholders Equity
The difficulty behind the ratio is two-fold. Most consider “all” the liabilities as demonstrated by the formula shown. But many choose to exclude all the short-term liabilities (accounts payables as an example) and include all the interest-bearing, long-term debt as a more accurate portrayal of the leverage. This is because the short-term liabilities do not provide us with a deeper comprehension behind the financial leverage the company has decided to employ.
If you are calculating the number yourself, you will soon discover numbers considerably different from those shown on the various websites around. Bottom line — know what you are looking at and if you aren’t certain, run the numbers yourself. Second, the research must continue beyond the simple calculation into the latest SEC filings. Some time back, I wrote an article for GuruFocus entitled, “What’s Important? Please See the Footnotes.” Go here:
In the article, I talk about off-balance sheet items such as pension liabilities or long-term leasing of stores as examples of items that must be considered during ones research. These are both examples of liabilities that should be included in the debt to equity ratio and typically are not unless you take the time to do it yourself.
It’s notable that Enron, Qwest, WorldCom and Global Crossing had debt to equity ratios that would not have garnered much attention. The highest of the foursome was Enron with a ratio of 0.89, well within most investors' acceptable range or benchmark of 0.5 to 1. Once off-balance sheet items were considered. However, Enron’s debt to equity ratio exceeded the acceptable range, exceeding 1 and would have at least caught the attention of a diligent investor.
WorldCom’s ratio was actually a good 0.52 (without looking at any off-balance sheet items). The numbers can confuse or be hidden quite easily unless you are prepared to do some additional work.
Another consideration for the investor is realization that stock buybacks can skew the ratio. For instance, a large buyback may diminish the size of the shareholders' equity, increasing the debt to equity ratio. In reality, the buyback is the culprit that caused the higher debt to equity ratio and might not really be a problem. So, once again, keep an eye out for stock buybacks or purchases and watch the effect on the shareholders equity.
Example: Debt of $1,000,000 to Equity of $1,000,000 gives a ratio of 1.
Taking $300,000 from shareholders equity to buyback shares reduces the total to $700,000 and we are left with 1,000,000/700,000 or a debt to equity ratio of 1.43. Is this good or bad? You be the judge.
Companies that have low debt to equity ratios may be failing their shareholders by not taking advantage of what the additional leverage may create in the way of profits. In other words, if the company, with the increase in leverage is able to increase their profits greater than the cost of the leverage or the interest, they are creating value. Alternately, companies with very high ratios may have difficulty in servicing their debt requirements or may be failing to create value.
As an aside, remember that during the economic upheaval we are currently experiencing, one would normally like to find companies with lower ratios, but the numbers by themselves mean nothing. We would hope that during a bad recession, a low-ratio company may better serve its shareholders by maintaining a strong position and be worthy of new loans, because banks obviously prefer the lower debt ratio when considering lending money.
Let’s give a simple example:
Company ABC has debt of $5,000,000 and shareholders’ equity of 8,000,000. Therefore, the debt to equity ratio is 5,000,000 / 8,000,000, or 0.63 — a little higher than some may want, but still an acceptable number ,or within the benchmark of 0.50 to 1.
Let’s assume they decide to borrow $2,000,000. This changes their debt to equity ratio because we now must add the $2,000,000 to the existing $5,000,000 of debt or $7,000,000. Now, the debt to equity ratio is 7,000,000 / 8,000,000 or 0.88.
If the company can borrow the money at 6% interest and produce a return of 10%, the decision to borrow the money may have well created value. If, however, the terms of the loan gets altered and interest rates increase to 8%, 9% or 10%, then the decision could be bad and place the company in jeopardy with the higher debt to equity ratio.
It is also advisable to consider this criterion along with the current ratio and interest coverage ratio. The
current ratio or current assets divided by current liabilities takes into consideration the short term items we discussed and indicate the ability of the company to meet their short-term obligations.
The interest coverage ratio allows the investor to look at whether the amount of debt is reasonable by seeing how much of the earnings are used to satisfy the interest on the debt. Bottom line, it is an indication of how hampered the company may be by the size of their debt. Interest coverage is calculated by taking earnings before interest and taxes or EBIT and dividing by interest expense or:
EBIT / Interest Expense
An example of how this we might view this:
As troubled as Walgreens (WAG) has appeared as a company over the last year, their debt situation appears considerably better in most areas over its competitors. I'm not making a judgement here as to the best investment. This is merely an illustration.
Remember to consider all of this as you seek to discover which are the strongest of companies with little or no debt that can bear the burden of a poor economy.
Stocks Discussed: WAG, CVS, ESRX,