Getting Down to Fundamentals, Part 1: Debt Ratios

(This is the first article in a three-part series looking at several key financial statistics that'll help you better evaluate companies in today's unsteady market.)

Part 1: Debt Ratios

Part 2: All About EVA

Part 3: Asset Management Ratios

With plenty of balance sheets looking a little tattered these days, debt ratios offer one of the easiest, quickest ways to gauge a company's financial health.

Sure, they won't tell you much about the va-va-voom, profit-related stuff, like earnings momentum or sales growth. Like other wholesome inventions -- shoulder-strap seat belts, peanut butter, flavored dental floss -- the subtle genius of debt ratios doesn't manifest itself in a flashy, forward manner.

But though their virtues go unsung, debt ratios can be indispensable for sussing out balance-sheet health. "If a recession's coming or we're in a recession, or a period of no growth, I think the balance sheet becomes more important. It can tell you if the firm has a strong enough financial position to get through this tough period," says Franco Wong, who teaches accounting at the University of California at Berkeley. That's because companies with debt will have to pay interest out of a stagnant or declining level of operating income. Those that can't pay debt, of course, ultimately go bankrupt, while those that struggle to pay lose credibility and run into further financing problems.

Debt ratios are best used as an introductory overview in analyzing a stock. "They can give you a quick [impression] of the health of a company," says Wong. "They can be good indicators, but you can't just focus on just one. And you should go from there and actually dig into the details, look at the footnotes" in the financial statements, he says, as well as scrutinize the income and cash flow statements.

There's a handful of commonly used debt ratios that show how much a company relies on debt financing. To demonstrate varying degrees of financial health, we've applied those ratios to three companies: cash-rich Microsoft (MSFT), which last year claimed earnings before interest, taxes, depreciation and amortization, or EBITDA , of $11.8 billion; hugely leveraged Amazon (AMZN), which had a negative cash flow of $340.7 million in the same year; and flailing Warnaco (WAC), the underwear manufacturer that has gotten pummeled for its troubles. The stock was changing hands for 39 cents when trading was suspended early this month. It recently filed for Chapter 11 bankruptcy protection.

We've picked these to show you how dramatically the amount of leverage can vary between healthy companies with low debt and lots of cash to service their debt, and troubled companies with lots of debt and a short supply of cash. But in practice, it makes sense to compare a stock's debt ratios with the industry average because different industries may tend to use varying amounts of leverage.

In short, while debt ratios can highlight potential problems, the appearance of a high-debt load may not necessarily mean a company's in trouble. In fact, comparisons can be misleading because even companies within the same industry may have different capital structures. It's a good idea to also consider the long-term trend of debt ratios within a given company.

The Debt Ratio

Now on to the ratios. First, the basic debt ratio simply compares debt to assets: total liabilities divided by total assets.

A look at its most recent 10-Q shows the debt ratio for Microsoft is: 11,515.0 divided by 59,605.0, or 0.1932. That very low ratio reflects that Microsoft has zero long-term debt, and its short-term debts are minimal relative to its massive assets.

In comparison with ultrasolvent Microsoft, Amazon looks positively decrepit. Its extremely high debt ratio (2,723.6 divided by 1.852, or 1,470.2) reflects that its total debts significantly outstrip its total assets.

Because of that unusual imbalance, Amazon's debt ratio isn't all that meaningful -- except to confirm that it's deeply indebted, which we already knew. According to Morningstar, interest from Amazon's $2 billion in debts consumes 3% of its annual revenue, putting a lid on future profits.

"Part of the reason for that [very high debt ratio] is that they've never shown a profit, so it's kind of an unusual case," says Michael Thomsett, the author of several investing books, including Mastering Fundamental Analysis. "I'm not sure even how you'd analyze them. There are no fundamentals -- there's no P/E ratio and no profit." The debt ratios of profitable companies are more meaningful, he says.

Turning to Warnaco, its debt ratio is 2,505.5 divided by 2,540.7, or 0.9861. In one sense, that ratio doesn't look as whacked-out as Amazon's. But it still represents failure on a pretty lurid scale. The ratio of debt to assets is practically one to one, meaning shareholders' equity is virtually nil. (Shareholders' equity represents the amount of money invested by shareholders, plus the profits -- or in this case, losses -- in the enterprise, and should be positive by definition.)

"In other words, the net worth is about zero," says Thomsett, "which means that because the debt is as high as it is, there's no capital to fund corporate growth, and no capital to pay dividends. Though it's kind of a moot question if they're gone."

As mentioned earlier, though, debt ratios should always be looked at in relation to the industry averages, which are presented in the table below.

Average Debt Ratio for Different Sectors
Sector	Debt Ratio
Advertising	73.74%
Aerospace/defense	58.81
Auto and truck	64.89
Beverage (soft drink)	53.65
Computer software	47.78
Educational services	31.89
Electronics	46.75
Entertainment	49.15
Environmental	53.67
Food processing	47.30
Grocery	64.05
Health care information systems	34.05
Home appliance	53.73
Home building	58.14
Hotel/gaming	49.23
Industrial services	49.66
Internet	51.32
Medical services	25.24
Newspaper	50.77
Paper/forest products	50.24
Restaurant	50.45
Retail store	58.59
Telecom services	53.23
Textile	59.12
Tobacco	40.46
Water utilities	52.63
Source: Value Line, March 1999.

The Current Ratio

Since Amazon's not profitable yet, it's probably more useful to look at its ability to pay debts that will come due within the next year. The formula for this, known as the current ratio, is: current assets divided by current liabilities (current assets are assets that can be converted into cash within a year).

As it turns out, by that measure things don't look quite so bleak. Amazon's current assets of $855.7 million cover its current liabilities of $604.7 million with a little left over, for a current ratio of 1.42.

Generally, it's considered good if companies have a current ratio of 2.0, or two times as many current assets as liabilities, and Amazon falls well short of that. Still, it would be able to service all its short-term debts in a crunch. "So cash in that sense is not as bad as you might think," says Berkeley's Wong. "In the short run, they will still be okay. Of course, after that, it's going to be tough to say."

Applying the current ratio to Warnaco, the picture gets far more gruesome. Warnaco's current assets of $873.9 million don't begin to meet current liabilities of $2,356.5 million; its current ratio is 0.37, meaning it can afford to cover only 37% of its short-term debts. No surprise it's now slinking down the corporate walk of shame to bankruptcy court.

The Debt-to-Equity Ratio

The debt to equity offers one of the best snapshots of a company's leverage. Basically, the higher the number, the higher the amount of leverage a company uses. A very high ratio of debt to equity would suggest greater risk for equity shareholders because creditors (debt owners) get dibs on assets first if the company were to go bankrupt. The formula for debt to equity is: total liabilities divided by shareholders' equity, where again, shareholders' equity equals the amount of money invested by shareholders, plus the profits or losses in the enterprise.

The debt-to-equity ratio for Microsoft is: 11,515.0 divided by 48,090.0 = 0.239. Again, that's a pretty low ratio, reflecting Microsoft's minimal liabilities.

For Amazon, the ratio is 2,723.6 divided by negative 1,253.4, or negative 2.173. As with its debt ratio, Amazon's debt-to-equity ratio has little intrinsic significance. "You can't use it because negative equity has no meaning," says Wong. Since Amazon is still a young company, Wong suggests investors might prefer to use the market value of its equity as a denominator in the equation, rather than the accounting number represented by shareholders' equity.

This would ensure you end up with a positive number because the market value of equity (price per share times number of shares outstanding) will be positive. "That may be a more sensible approach for a start-up. Most have negative equity on the book," he says. Using the book value of equity probably makes the most sense for older, established companies.

Using the market value approach, 358.8 million shares outstanding times $10.4375 (the closing price on March 1, the date listed in the most recent quarterly balance sheet) equals about $3,745 billion in market equity. So 2,723.6 divided by 3,745.0 = 0.7273, which still makes Amazon a highly leveraged company.

But it looks miles better than the debt-to-equity ratio of flaming loser Warnaco. As of its most recent 10-Q (its last, at least in the company's present form), Warnaco's debt-to-equity ratio was 2,505.0 divided by 35.0, or 71.571.

En route to achieving that standout number, Warnaco would have posted a series of increasingly ugly ratios that reflected its deepening debt. Setting aside Warnaco's strategic and legal messes for a moment, investors who paid attention to the increasing burden of debt alone probably would have managed to extricate themselves well before the stock lost 94.3% of its value in the past year.

As with all these measures, though, you shouldn't look at debt-to-equity ratios in isolation. For example, automaker Ford(F) has a debt-to-equity ratio of 9.0. That may seem high, but it's not out of line with the auto industry overall because automakers tend to carry a lot of finance receivables and leases on their balance sheets. "You can't really apply the standards for an industrial company, strictly speaking," says Scott Spritzen, an auto analyst with Standard and Poor's corporate ratings group. "Ford carries a lot of debt, but it has a lot of liquid assets like retail auto loans and wholesale loans, and it carries a lot of cash, too." At the end of the first quarter, Ford claimed $5.38 billion in cash and generated $33.7 billion in EBITDA.

In short, while debt ratios can't tell you that much in isolation, looked at in context and over time, they can be a supremely handy tip-off to worsening debt troubles. And identifying those situations early on could save you a lot of money.

Leveraged to the Hilt A high debt-to-equity ratio may raise a red flag at companies with low or negative cash flow (screen of domestic stocks with market cap of at least $1 billion and debt-to-equity ratio greater than or equal to S&P 500, ranked from highest to lowest ratio)
Company	Industry	Debt-to-Equity Ratio FY1	YTD Return	2000 EBITDA (in millions)	Market capitalization (in billions)
Rite Aid (RAD)	Stores, retail	52.8	310.1%	291.2	$3.3
Amphenol (APH)	Semiconductors	24.0	2.9	289.5	1.7
Maytag (MYG)	Electric equipment	20.8	-3.2	627.8	2.4
7-Eleven (SE)	Groceries	20.0	41.7	367.2	1.3
Allied Waste Industries (AW)	Waste services	14.2	23.6	2,009.9	3.5
Triton PCS Holdings (TPCS)	Wireless communications	13.1	4.9	-30.8	2.2
International Game Tech (IGT)	Miscellaneous Manufacturing	10.3	30.9	324.4	1.2
Solutia (SOI)	Chemicals	9.8	14.8	203.0	1.4
Ford Motor (F)	Auto makers	9.0	4.9	33,667.0	44.2
Campbell Soup (CPB)	Food manufacturing	8.9	-19.0	1,550.0	15.0
All-stock average		1.3
S&P 500		0.9
Source: Morningstar.

Coming Tomorrow: Getting Down to Fundamentals, Part 2: Economic Value Added

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