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.

Actually, IBM looks smart. The company has high borrowings, increasing its performance, yet the cost of that leverage isn't eroding earnings much. IBM's shares have risen 64% over the past year, more than the S&P 500 Index's 34%, and Cisco's and HP's 56% and 47%, respectively.

The opposite also can be true. A seemingly low debt-to-equity ratio can be less attractive under closer examination. Alcoa, for instance, posts a respectable debt-to-equity ratio of 0.62, yet its interest coverage ratio is far less attractive.

Similarly, industrial companies General Electric and Caterpillar look to be insanely highly leveraged compared with Alcoa, with debt-to-equity ratios of more than 4 for each. Yet both also post interest coverage ratios of about 1.5, much like Alcoa's interest coverage ratio of 1.8.

Alcoa's share performance has been in line with the market as a whole over the past year, gaining 34%, yet it falls far short of Caterpillar's increase of almost 60%, thanks in large part to Caterpillar's leverage boost. General Electric has underperformed both, but the stock also has been dragged down by shaky businesses such as NBC Universal and financing.

Wal-Mart and Alcoa have similar debt-to-equity ratios, yet Wal-Mart manages an interest coverage ratio of 11.5, as companies with low debt levels should.

Gross debt levels are important to monitor, but it's important to put them in context with a comparison to operating results. Look for companies that can use leverage responsibly and in a way that doesn't impede earnings.

-- Reported by David MacDougall in Boston.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.

If you liked this article you might like

Warren Buffett Is Sticking to His Strengths By Selling IBM and Buying More Apple

Warren Buffett Is Sticking to His Strengths By Selling IBM and Buying More Apple

Five-Day Winning Streak in Stocks Expected to Continue

Five-Day Winning Streak in Stocks Expected to Continue

Bitcoin Today: Prices Burst Through $10,000 as Traders Mitigate Stark Warnings

Bitcoin Today: Prices Burst Through $10,000 as Traders Mitigate Stark Warnings

Apple Stock Is Being Bought by Warren Buffett; Should You Buy It?

Apple Stock Is Being Bought by Warren Buffett; Should You Buy It?