Considering the wild roller coaster ride the world’s markets have put us through the last few years, it is no wonder even the most aggressive retail investors are looking for less risky investments. Ratio analysis can provide a roadmap and of the many financial ratios available, the ones that offer us the best clues are debt ratios and liquidity ratios.
Simply put, companies with high debt levels can get in serious trouble when unexpected bumps appear on the economic road. When American investment banking giant Lehman Brothers failed, credit markets worldwide began to freeze. Without access to credit, debt-laden companies everywhere found themselves in dire circumstances and the investment community acted accordingly – selling off shares in panic.
Strictly speaking, debt ratios such as debt to assets and debt to equity are subsets of the category of financial ratios called leverage ratios. A broader definition of “leverage” includes the concept of gaining an advantage and in financial parlance; leverage is equated with taking on debt to give a company an advantage. The advantage comes from the classic idea of using “other people’s money” for your capital needs rather than your own.
On smooth pavement, leverage or debt can be a good thing but when conditions begin to deteriorate, highly leveraged companies are at substantial risk from the condition feared by investors everywhere – bankruptcy. If a company has taken on more debt than it can handle, especially in the short term, the risk of serious trouble ahead is very real. Indeed, not all will end up in bankruptcy but once the investment community sniffs out potential trouble, share prices can decline rapidly in the midst of sell-offs.
The Debt to Assets Ratio
When looking for companies with less leverage risk, start with the debt to assets ratio, which is calculated as follows:
Total Liabilities / Total Assets
You can find both total liabilities and total assets on a company’s balance sheet. A company with $1,000,000 in liabilities and $5,000,000 in assets has a debt ratio of 20%. As a general rule, the lower the number, the less risk involved in buying a company’s shares. As is the case with all ratios, you need to look at the company’s historical performance – has the debt ratio increased and if so, why. You also need to compare the company you are considering against its key competitors.
The debt to assets ratio is easy to calculate and provides a broad picture of a company’s debt compared to its assets. This is important for investors since in tough times a company may have to resort to liquidating assets to pay debt.
However, like most ratios, the debt to assets ratio alone is nothing more than a general indicator requiring further investigation. Few financial sites with pre-calculated ratios even list the debt to assets ratio, instead preferring another measure of leverage – the debt to equity ratio. Taken alone, the Debt to Assets Ratio tells you nothing about who “owns” the debt – the company’s shareholders or its creditors.
Businesses reach a point where they need capital to expand. A new company can elect to enter the public markets and sell ownership shares as a means of raising capital. They can also borrow from creditors. Established companies faced with the need for additional capital have the same options. They can issue new shares to raise money or they can borrow. As you know, creditor debt takes precedence over shareholder equity.
The Debt to Equity Ratio
The Debt to Equity Ratio tells you the percentage of the company’s capital that came from creditors versus shareholders. The formula for calculating the Debt to Equity Ratio is as follows:
Total Liabilities / Shareholder Equity
This ratio is widely used and you can find it pre-calculated on many Australian financial websites. As an example, Australian giant BHP has a Debt to Equity Ratio of 19.1, or roughly 19%. Lower numbers like BHP’s 19% indicates the company uses less leverage and is generally a safer investment.
Companies with Debt to Equity Ratios of 40% to 50% or more pose a potential risk that goes beyond bankruptcy – declining share price in the face of trouble. If something negative happens in the broader economy or within the sector in which a company operates or within the business of the company itself, investors everywhere sit up and take notice. A highly leveraged company that loses a major customer faces declining revenue. Even if they are able to stave off bankruptcy, it is highly likely some investors will want to protect themselves and get out, driving the share price down.
Larger companies such as BHP can sustain higher levels of debt, which leads some investors to believe Debt to Assets Ratios and Debt to Equity Ratios are more suitable for analyzing smaller companies. However, not even large companies can fend off declining share prices if enough investors become convinced their leverage position is problematic.
There is an additional category of ratios that can help identify shares with lower risk. These are liquidity ratios. They measure a company’s ability to manage short-term debt in tough times.
Liquidity is a measure of how quickly you can convert an asset into cash. If you have experienced a personal financial setback, you can sell shares easier than you can sell your home. Liquidity ratios look at the relationship between what a company owes right now – its current liabilities – and what it owns right now – its current assets. Current assets include cash instruments, marketable securities, inventory, and accounts receivables. Let’s look at the two most commonly used liquidity ratios.
The Current Ratio
The formula for the Current Ratio is as follows:
Current Assets / Current Liabilities
Although you can find these numbers on a company’s balance sheet, most financial websites have done the math for you and include this ratio with their key indicators for evaluating the shares.
With liquidity ratios, higher numbers represent safer financial cushions against economic shocks. A company with a high current ratio should have no trouble meeting its short-term debt obligations without sacrificing operational capability.
However, taking the Current Ratio at face value without considering the nature of the company’s assets can lead to trouble. This ratio assumes an easy conversion of an asset into cash, which is not always the case. You need to know how quickly the company collects its receivables and how frequently it turns its inventory.
There are two additional ratios to address this issue – the Quick Ratio (Acid Test Ratio) and the Cash Ratio. We will get into these ratios next week.
In summary, few things can drive an investment into the ground quicker than the company’s debt and its ability to manage debt. While they do not provide a magical answer, Debt to Assets Ratios, Debt to Equity Ratios, and Liquidity Ratios can help you identify shares that pose less risk.