Debt Ratios

I used 4 basic debt ratios. Two have to do with assets and liabilities and two have to with equity (Shareholders’ Equity or Book Value) and its relationship to liabilities and assets. These ratios are balance sheet ones. There are a lot of different ratios you can use. What I am trying with my spreadsheets is to use a number of approaches to get different views of a stock. With these debt ratios I use I am trying to see if there are any problems than need further investigation.

The first one is the Liquidity Ratio and it is Current Assets/Current Liabilities. This is also called the Current Ratio. The next is the Asset/Liabilities Ratio and it is Total Assets/Total Liabilites. Ideally, for both these ratios you are looking for one of 1.50. That is assets are 1.5 times the liabilities. These ratios are also sometimes called Balance Sheet ratios.

With the Liquidity Ratio you are looking to see if a company has the ability to pay off their short term debts. If the ratio is less than 1.50, you might also want to look at the ability of the company to pay dividends and fund their short term debts (unfundable from short term assets) from cash flow. Also, you may want to see a higher ratio (i.e. 2.00) if you feel that the company would have a hard time borrowing money on a short term notice.

Also, some people use what is called the Quick Ratio which is Current Assets-Inventories/Current Liabilities. This is useful on companies which may have inventories that cannot readily been turned into cash. Inventories could have old products in them, or items in the inventory could be not readily sold in the current business cycle. This is compared to an inventory of new products easily sold.

Investopedia has a tutorial on this subject on site.

Asset/Liabilities Ratios are one way of looking at debt levels. Other Ratios look at Debt/Asset Ratio (Liabilities/Assets). These ratios are used to measure the long term solvency of a company. The higher the ratio, the better off the company is. This ratio can measure the financial risk of a company.

If the Asset/Liability Ratio is less than 1.00, then you should carefully review a company. It could be pointing to a company in difficulties. This is because the assets of a company cannot cover the company’s liabilities.

The next ratio to discuss is the Leverage Ratio or Assets to Book Value (or Shareholders Equity). This ratio shows how much of a company’s assets are owned by the company (or its shareholders) and how much are leveraged or financed through debt. This ratio strongly depends on the type of industry a company is in.

Read definitions of this ratio at Dogs of the Dow investor glossary, Wall Street Survivor site and at Investopedia.

Debt/Equity Ratio is another ratio I use. It is Total Liabilities/Shareholders Equity. This is also used to measure the long term solvency of a company. In the debt portion of this ratio, you may want to use just debt (short term and long term debt), or just use long term debt. It is important to realize that if the ratio is greater than 1, the majority of assets are financed through debt. If it is smaller than 1, assets are primarily financed through equity.

Read definitions of this ratio at Investor Words and Investor Words.

For this ratio, one of around 0.50 or below probably points to a company with no debt or very minimal debt. I just reviewed Computer Modelling Group Ltd (TSX-CMG) and its recent debt/equity ratio is 0.64. It has minimal debt. I reviewed it on my blog in June 2011. Click here or here to access its blog entries. See my spreadsheet at cmg.htm.

If it is high, the company is probably using debt to finance its operations. Utility companies often have high ones. I reviewed Enbridge Inc. (TSX-ENB).in April 2011 and its recent debt/equity ratio is 2.94. It heavily uses debt to finance its operations. Click here or here to access its blog entries. See my spreadsheet at enb.htm.

You would want to compare the current debt ratios to the historical debt ratios of the same company. You also want to compare a company’s ratios to similar companies in the same industry. These ratios only give you an indication on how a company is doing; you need to look at a number of things to get a complete picture of how well a company is doing. Also, the account methods a company uses can significantly affect these ratios.

Also, sometimes companies have what is called loan covenants that specify certain debt ratios that a company must maintain. If they do not, certain things must happen. Often, if they do not keep the loan covenants, dividends will be cut or discontinued until such time as the debt ratios meet the terms of the loan covenants. A company is said to have a “Clean Balance Sheet” if it has little or no debt.

There is a blog on accounting statements at Accounting Coach. This blog has a good articles on the Balance Sheet; the Income Statement; and the Cash Flow Statement.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website for stocks followed and investment notes. Follow me on twitter.