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TheStreet Open House

IBM's Debt Mirage: Analyst's Toolkit

BOSTON ( TheStreet) -- A big debt load can send investors running for the hills. But the ability to carry debt is more important than its sheer size.

General Electric (GE), IBM (IBM) and Caterpillar (CAT) have high debt-to-equity ratios but that doesn't necessarily mean they're riskier than Alcoa (AA), Cisco (CSCO) and Wal-Mart (WMT), which have low debt-to-equity ratios.

Pairing the debt-to-equity ratio with a similar gauge of financial risk, the interest coverage ratio (sometimes referred to as times interest earned), provides a complete picture of a company's risk. That addition might portend an earnings pinch due to financing costs.

The interest coverage ratio is simple to calculate: earnings before interest and taxes (EBIT) divided by interest expenses. Those figures are listed on the income statement. The ratio shows how easily operating earnings cover interest expenses. The higher the number, the better.

If IBM, Cisco and Hewlett Packard (HPQ) were compared based on the debt-to-equity ratio, IBM would look risky. With a debt-to-equity ratio of 1.38, IBM appears to be carrying far more debt financing relative to its size than HP and Cisco, which have ratios of only 0.41 and 0.26, respectively.

Once the interest coverage ratio is applied, the view changes drastically. IBM's interest coverage ratio is a whopping 53, while Cisco is comfortable at 20.6 and HP has a respectable 5.4. While the financial health of Cisco and HP isn't called into question by this addition, it does vindicate the seemingly highly leveraged IBM. As such, IBM is free of any concerns about a debt drag that may have been raised by the debt-to-equity ratio alone.

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