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What a difference a year makes when it comes to attitudes towards corporate gearing. Companies once lauded for having ‘ballsy borrowings’ are now as popular as Scrooge himself on Christmas morning.

The global credit squeeze brought to front and centre the stress debt can place a company under. And the 180-degree about-face on what now constitutes a troubling amount of debt brought with it a wave of subsequent downgrades.

So exactly where do investors find a company’s debt levels?

According to Roger Montgomery, managing director of Clime Asset Management there’s no better measure than the net debt-to-equity ratio, which is a measure of total net debt compared to shareholders’ equity. All figures needed to calculate this ratio can be found in a company’s statement of financial position or balance sheet.

So assuming debt is a moving beast, how can investors decipher if a stock’s current level is too high?

While investors may start delving into interest cover ratios, Montgomery says it’s much safer to simply avoid companies carrying too much debt. He says the best businesses are those that don’t need to borrow and recommends giving companies that grow by acquisition a wide berth.

He cites (one-time) blue-chip stocks like Wesfarmers and Rio Tinto (and even ABC Learning Centres) as classic examples of stocks whose balance sheets have been compromised by excessive borrowings – and the recent damage to RIO’s fortunes is hard to ignore.

It was the prospect of repaying RIO’s net-debt to equity ratio of 114 per cent within difficult near-term economic conditions that forced BHP to withdraw its bid for the London-based miner. “It’s a misnomer to assume there’s some safe threshold of borrowing – it’s all relative to the quality of the balance sheet and the stability of future earnings,” says Montgomery.

Clime Asset Management avoids buying stocks with more than 50 per cent net debt-to-equity. Interestingly, there are no fewer than 450 ASX-listed stocks where the net debt-to-equity position is one or more. In other words, for every $1 of equity, they’re carrying over $1 in debt.

Key figures within the balance sheet, notably total liabilities, net shareholder equity, cash equivalents, and interest bearing debt (or longer term debt) provide strong clues as to the difficulty a company might get into if there’s pressure on its EBIT (earnings before interest and tax).

In looking purely at debt levels, some stocks are certainly geared to the max. Trading on $1.64 equity per share versus $16.09 in borrowing per share, Macquarie Communications Infrastructure Group (ASX:MCG) is the ASX’s most debt-laden stock.

Total shareholders’ equity in MCG is a measure of the net assets in the business (total assets less total liabilities), which comes to $816 million.

To work out the net debt-to-equity (gearing ratio) investors need to take a few more items off the balance sheet. These include subtracting the $516 million in cash (an asset) from interest bearing debt of $8,439.8 billion (a liability). The difference equals net debt of $7,923.5 billion – which when divided against $861 million in total shareholders’ equity gives a gearing ratio of 920.3%.

Investors should also note the quality of a company’s assets. Closer analysis of MCG shows that of $12.4 billion in total assets, more than half ($7.2 billion) is made up intangible assets – a whopping $5.7 billion represents goodwill. A further $3.3 billion is in hard assets – plant & equipment – the value of which is highly subjective within the current market.

Despite reporting a total loss over a five year period, between 2004 and 2008 the entity paid $644 million in dividends and has had to raise debt/equity to pay it. “Raising $1.8 billion in new share capital and borrowing $8.4 billion to fund growth and dividend payments to shareholders is an unsustainable business model,” says Clime analyst Russell Muldoon.

But Elio D’Amato, CEO with Lincoln Indicators warns against looking at debt ratios in isolation. He says it’s equally important to include other factors, like a robust scrutiny of any unusual change in debt levels and whether dividends and working capital can be funded out of cash-flow. He says while JB Hi Fi, Sonic Healthcare or even Woolworths trade on higher than desirable net debt to equity (76%, 50.4% and 34% respectively) they’re seen to have sufficiently strong cash-flow and retained profits to absorb debt or meet any unexpected impact on operations.

And while JB Hi Fi’s $1.55 equity per share versus $1.18 in borrowing per share might typically be of concern to investors, he says it needs to be viewed against the interest rate environment and prevailing consumer cycle.

Net debt-to-equity aside, another useful measure D’Amato favours is current liabilities (or shorter-term debt) to total liabilities and prefers the ratio to be well under 0.70%. “The more debt a company has within the next 12 months the greater the risk, and that’s doubly true within the current liquidity squeeze,” he says.

When comparing total liabilities to total tangible assets – another useful measure – he likes to see a ratio under 0.57%. Calculated as total debt divided by total assets (excluding intangibles like goodwill), this ratio compares debt to actual core assets the company owns. And based on these numbers Omnitech Holdings Limited (ASX: OHL) and Imagine Un Limited (ASX: IUL) top the ‘total liabilities to total tangible assets’ table with ratios of 69.18% and 19.68% respectively.

Ironically, D’Amato says while under-geared stocks were highly lambasted by brokers a year ago, a lazy balance sheet is now regarded as good and risk-aversion is very much back in vogue. “People are starting to remember that debt actually has a cost.”

Top 10 Debt to Equity ratios – calculated as short term debt + long term debt – cash divided shareholders equity

Company Debt/Equity Ratio

Macquarie Communications

920.3%

AMP Ltd

527%

Flexigroup Ltd

383%

West Australian Newspapers

359.8%

Duet Group

358.1%

Speciality Fashion Group

350.9%

Quantum Energy Ltd

340.4%

AWB Ltd

307.2%

Babcock & Brown Infra

305.4%

Boart Longyear Ltd

259.2%

Top 10 Total Liabilities to Total Tangible Assets (calculated as Total Debt / Total Assets – Intangibles)

Company Debt/TTA

Omnitech Holdings Limited

69.18

Imagine Un Limited

19.68

Monteray Group Limited

15.07

Acma Engineering & Construction Group Ltd

12.59

Run Corp Limited

9.84

GoConnect Limited

7.74

Vesture Limited

7.62

EnviroMission Limited

6.69

Resource and Investment Nl

5.07

Byte Power Group Limited

4.29

Source: Stockval