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Booyah Breakdown: Debt Uncovered

Tracy Byrnes

Editor's note: Welcome to "Booyah Breakdown," an explanation of terms and topics Jim Cramer discusses on his "Mad Money" TV show. Feel free to ask a question if you're confused about something Cramer talks about, but please keep in mind that we do not provide advice on specific stocks.

Sometimes it's actually easier to understand the idiosyncrasies of your 4-year-old then it is to understand the logic surrounding financial-statement analysis.

(Although I will forever be dumbfounded at the need to drop to the floor and scream when the right bows aren't put in your hair.)

But since reading the financials is part of the Cramer's homework assignments, we have to decipher them.

One part of homework that Cramer constantly emphasizes is the need to analyze a company's total debt liability. You need to know if the company has enough money to pay its bills. Logic tells you to go to the company's balance sheet to find the debt numbers. But since logic sometimes pulls a tantrum outside of dance class for no apparent reason (I swear), you have to be patient and dig deeper for the full story.

Believe it or not, some of your company's debt liability is tucked away in the footnotes to the financial statements that come after the cash-flow statement -- not on the balance sheet.

You can thank the Financial Accounting Standards Board for the enigma. The accounting lawmakers decided moons ago that if a company doesn't own the asset it's financing, it doesn't have to report the corresponding liability on the balance sheet.

Hmm? So if a company doesn't own the building it's leasing, it's not really an asset. Therefore it's not a real liability and it should go in the footnotes. Makes sense, right?

Hardly! It's still debt! Management still needs to make that lease payment at the end of the month.

Granted, management isn't trying to pull the wool over your eyes. It's the FASB's rule. But since less debt on the balance sheet means a higher shareholder's equity balance, management is thrilled to throw some extra debt to the back of the book.

To get a true picture of the company's total debt liability, you need to crunch some numbers.

The biggest off-balance sheet obligations (a.k.a. off-balance sheet financing, off-balance sheet liabilities, off-balance sheet accounts) are operating leases, pension liabilities and special-purpose entities.

Thankfully, FASB took care of the SPE problem after Enron blew up (too little, too late, no?). But the other two items are hot these days.

Lease for Free

There are two basic types of leases: operating leases and capitalized leases.

In very, very simplistic terms (because someone is bound to email me), if you lease an item that doesn't have a special buyout option at the end, FASB says you can't really call that asset your own. The accountants dub that an "operating lease," since you essentially return the item when the lease is over.

So leasing a car for three years would be considered an operating lease. (Too bad I can't tell the credit agency to exclude that debt from my credit score.)

But let's say you instead take out a loan and buy the car outright. While you still need to make payments on the loan, you now own the underlying asset, so that lease would be called a "capitalized" lease and be reported on the balance sheet, says Dan Noll, director of accounting standards at the American Institute of Certified Public Accountants.

There's nothing wrong with having operating leases. They're totally legit. But the temptation to get some debt off the balance is a big one, so many companies structure their leasing deals as "operating."

Take Starbucks (SBUX - Cramer's Take - Stockpickr). The company leases most of its coffeehouses and has no obligation to buy the buildings at the end of the leases. That means all those buildings are under operating-lease contracts and will not show up on the balance sheet.

But it's still debt to Starbucks. Go to the footnotes and you'll find an extra $2 billion (yes, billion) in long-term debt in the company's financials at the end of its last fiscal year, according to Ed Ketz, associate accounting professor at Penn State University.

Same goes for CVS (CVS - Cramer's Take - Stockpickr). It leases many of its stores, and the deals are structured as operating leases.

CVS' long-term debt jumps from $2.3 billion to almost $14 billion when you add in its long-term lease oblations, notes Ketz.

Do the same exercise for the airline industry, since many of their planes are leased, and you'll probably feel something akin to motion sickness.

Pick Up the Pensions, Please

The pension liability is a joke, too, because we all know now that the pension plans at most companies are underfunded. What's worse, to truly realize how underfunded they are, you again have to dig through the footnotes.

Here's the arcane logic: Since pension assets belong to the employees, in theory, they're not an asset to the company, so the company, therefore, can't record a corresponding liability on the balance sheet.

You will find a pension liability on the company's balance sheet, but it doesn't represent the whole picture, thanks to FASB's logic. You have to read the footnotes for more detail.

It's not uncommon to have a huge pension liability number these days. As an example, say your company has saved $400 million in pension assets. But if everyone retired, the company would need to pay out $900 million. So the company is short $500 million at this time. That's a big fat liability that should clearly be in the balance sheet. But it's not.

The upside is that FASB is expected to issue a statement any day now requiring companies to report the true net pension liability on the balance sheet, says Noll. Hey, it's something.

Get in Balance

At a minimum, read those off-balance sheet footnotes and understand what's out there.

Ideally, you should run a quick debt-to-equity ratio, says Ketz. It's just long-term debt divided by shareholder's equity, and it measures a company's financial leverage. So if the company had to liquidate today, could it pay all its bills? You're looking for a low number.

To get a true ratio, add all the extra debt from the off-balance sheet financing note.

Let's pick on Starbucks again. Just using its balance-sheet number, its debt-to-equity ratio is 0.68. Add in all those leases, and it more than triples, reaching 4.58. And that doesn't include the pension stuff. "Clearly, Starbucks is leveraged more greatly than it admits," says Ketz.

So don't waste your time trying to understand why some items are not in the financials statements and why some kids throw tantrums when their pizza is cold.

Just be smarter and go with it. Carry a calculator and a flask so you can crunch some numbers to understand the real deal and take a swig when the screaming starts to hurt your eardrums.