Financial strength – the debt equity ratio has serious shortcomings

Financial strength

When rock solid isn’t

There are two ways of looking at company debt. The first is to look at the amount of debt in relation to the capitalization of the company. Traditionally this is the debt equity ratio. The second is to look at it from the point of view of the ability of the company to service and pay back the debt.

When we are done I hope the reader will look at the debt equity ratio in a whole new light.

Let’s look at the first way: the debt equity ratio. Debt equity ratios are not always what they seem. As usual, when reading and interpreting financial statements, discernment is required. As Warren Buffett put it in his 1986 Chairman’s letter: “…accounting is but an aid to business thinking, never a substitute for it.”

For some companies a simple debt equity ratio based on the book value of equity gives a useful read as to the strength of the balance sheet. For many other companies, particularly those which have developed substantial Economic Goodwill and internally generated intangible assets of lasting value, the debt equity ratio may produce strange results. Many think a financially solid company will have a debt equity ratio of no more than about 1:1, i.e. a dollar of debt per dollar of equity. To read more about Economic Goodwill see: The hunt for wonderful businesses

Colgate Palmolive, a household name blue chip company with a current market cap of about $58 billion has a Long-Term Debt/Equity ratio of 62.7. It long term debt today is $7,333 million compared with total equity of $117 million. I’m not making this up. 

The explanation is that a company with a high debt equity ratio may still be financially strong if it has substantial Economic Goodwill and economic intangible assets that aren’t reflected on the balance sheet. So, if you restrict your purchases to companies with low debt equity ratios you will miss some wonderful opportunities.

The flip side isn’t always clear either. Many think a company with a low debt equity ratio based on the book value of equity will likely have a strong financial structure; unless of course it is a Penn Central type situation.

In June of 1970 when Penn Central,the sixth largest corporation in the U.S., declared bankruptcy, it had a book value of equity of $60 per share. It was, at the time, the largest bankruptcy in American history. Its problem wasn’t a high debt equity ratio. Its problem was that it simply wasn’t able to service its debts. So, if you accept that companies with oodles of equity in relation to debt are rock solid you can get into trouble. Book equity may not be all it is cracked up to be. See my post: The fading usefulness of book value

Coverage ratios

Let’s look at the second way of assessing the financial strength of a company. A coverage ratio is a way of looking at how easily a company can handle its debts. This is a good way of measuring its financial strength. There are two basic types of coverage ratio.

The first shows us how easily a company can handle to interest and principal payments on its debt. The second tells us how easily a company can pay off its debts in full. For investors the second is the most important measure. The first is more for use by bank credit officers.

We will only discuss the second as it will serve to keep us well away from companies that have trouble paying their debts.

This ratio can be identified by simple inspection of a company’s financial statement or from the numbers contained in analysts’ reports. It answers the question of how long it would take, notionally, for the company to pay off its long term debt if it chose to use all its free cash flow to do so. One benefit of using free cash flow is that since it is derived from operating profit it smooths out many extraordinary items.

A ratio of net long term debt to free cash flow of less than 5:1 is comfortable. This represents a very sound balance sheet. A ratio of 3:1 or less indicates a rock solid balance sheet. A ratio of more than 5:1 indicates that management is content to lever its balance sheet for some reason and that debt will be a significant factor with the company. I recently exited a company I had held for a long time because management and the board carried out a series of acquisitions which led to a net long term debt to free cash flow ratio above 7. I had no problem with the acquisitions. I didn’t like the leverage.

If the company has a large amount of cash on hand, long term debt can be reduced by an amount of cash that exceeds the company’s normal operating needs for cash. For most companies no deduction is needed. If a company’s net long term debt is three times its free cash flow it would notionally take the company three years to pay off its long term debt. An investor can also add back some one-time special non-repeating expenses that have reduced free cash flow. Management will offer suggestions in their reconciliation of adjusted earnings. It’s a matter of common sense.

When I originally looked at this a year or so ago, Colgate-Palmolive Co. reported long term debt of $6.2 billion. It had free cash flow of $2.2 billion in the year. If it chose and its debt holders agreed, it could pay off all it long term debt in less than three years from free cash flow.

The Charles Schwab Corporation, a large and profitable investing services firm reported long term debt of $2,890 million and free cash flow of $980 million. The long term debt could be paid in less than three years.

C.H. Robinson Worldwide Inc., a truck broker, shows $500 million of long term debt in its most recent annual statement. Its free cash flow during the year was $680 million. It could, in theory, pay off its long term debt in less than a year. It is in a rock solid financial position.

The net long term debt to free cash flow ratio is not without its subtleties. Free cash flow can be lumpy in even the best companies. As well, long term debt can change significantly from year to year particularly if a company makes acquisitions. Inspecting five years of free cash flow data, five years of capital spending and the same five years of long term debt gives a fairly complete picture of the financial strength of the company. It is obvious what the ratio between long term debt and free cash flow is at any moment and also how the ratio has progressed or regressed over the five year period.

Conclusion re coverage ratios

In using these ratios one is not trying to make fine distinctions. One is not trying to determine whether the company is a six footer or a six foot sixer. After all, in the language of Warren Buffett, we are looking only for seven footers. We are looking for rock solid balance sheets. We are looking for strong financial health. We are not trying to determine whether the company is meeting the interest and principle payments on its debt with ease or less ease. No company under our consideration will even be close to scrambling to pay its creditors.

For readers wanting to dig deeper into the subject of how to identify and assess great companies, take a look at Part 6: The Hallmarks of Superb Businesses

In particular, see Chapter 35. Capital Structure, Strength and Economic Performance

The above post is condensed. To read further about assessing the financial strength of companies see Sections:

35.09 General discussion of debt and debt equity ratios

35.10 Debt to equity ratio conclusion

35.11 Financial strength

35.12 Net long term debt to free cash flow

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