How to Tell If a Company Is Drowning in Debt

How to Tell If a Company Is Drowning in DebtToday brings us to part three in a continuing series that spotlights the major computations found here at DailyFinance. It's a short course in Mathanese -- aka, the numbers behind investing's (and life's) big equations.

Last time, we covered free cash flow. Today, we're on to the equally important debt-to-equity ratio.

Like consumers, companies can take on too much debt. The debt-to-equity ratio offers one way to tell whether a leveraged business is taking on too much.

Companies That Play in the Deep End Sometimes Drown

Remember the debacle of 2008? If you read past the headlines, you may remember some rumblings about the debt-to-equity ratio. Heavily leveraged banks fell apart as a looming recession limited access to cash. They owed too much to handle a liquidity crisis, and the phrase "Too Big to Fail" entered the national lexicon.

The problem has not gone away. Futures brokerage MF Global filed for bankruptcy protection as a result of its own liquidity crisis, brought on by fears that a big investment in European debt would go bad. The ensuing panic left MF Global searching for a cash infusion to cover its commitments. It couldn't find one.

In the case of MF Global, as of Sept. 30, debt equaled more than 15 times equity. Other highly leveraged companies include SBA Communications (SBAC), CIENA (CIEN), and satellite-television operator DISH Network (DISH). SBA, in particular, has 180 times more debt than equity.

When Debt Is Poised to Become a Crisis

How can you tell if you own shares of a company that's diving into the deep end of the debt pool? Easy. On the balance sheet, add up all sources of debt (i.e., short-term debt, current portion of long-term debt, long-term debt) and divide by total equity, expressing the result as a percentage. Here's the equation:

[Total debt / total equity] x 100

And here's the equation when you plug in the numbers for SBA, which as you'll see includes soon-to-be-due debt ($5 million) and long-term debt ($3,334.2 million):

[$3,339.2 million / $18.5 million] x 100 = 18,049.73%

Why You Should Care About This Metric

Looking at the debt-to-equity ratio is one way to see whether a company is taking on too much. Other options include looking at working capital and comparing interest paid to operating income. Businesses that pay more in interest than they collect in profits don't usually stay in business long.

Conversely, companies that use a modest amount of debt to boost profits while paying low or even below-market interest rates can grow faster than their peers. The difference is knowing the line between "not enough" and "too much." Usually, it's when debt equals more than 100% of equity, which is why it's important to be able to do the math.

Have something to say? Please let us know by leaving a comment. You can also notify Tim by replying to him on Twitter, where he posts as @milehighfool.

Motley Fool contributor Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Check out Tim's portfolio holdings and Foolish writings.

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17 Comments

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blackwhitemingle-com

Nice to be here :)

March 16 2012 at 10:41 PM Report abuse rate up rate down Reply
arilede4

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December 26 2011 at 8:37 AM Report abuse rate up rate down Reply
johnny757

um if you read it thoroughly you wouldn't be making this dumb post about it being a WEAK balance sheet. Because it says "3334.2 million in long-term debt.... @ "cantbelievemyears"

December 01 2011 at 3:27 AM Report abuse rate up rate down Reply
cantbelievemyears

Before jumping to grandiose comparisons of how our country has too much debt, etc. did anybody actually digest the fact that this article comes to absolutely no relative conclusion regarding debt to equity?? If a company has 3.3M of debt and 18.5M of equity this company would have a STRONG balance sheet and not a weak one. The article is implying just the opposite! Or am I mistaken in my assumption that "18,049.73%" would be perceived as negative when it is simply a completely useless product of a completely misapplied mathematical equation?? And THAT is what is wrong with society today - nobody picks up on the insanity of the words that can come out of what are supposed to be "knowledgeable" mouths!

November 30 2011 at 2:04 PM Report abuse rate up rate down Reply
detkoncp

AND NOW OUR FED. RESERVE IS BAILING OUT EUROPE. WHERE WERE THE EUROPEANS WHEN OUR BANKS WERE FAILING????

November 30 2011 at 12:04 PM Report abuse rate up rate down Reply
bbpincorp

Rick Perry says if your under the age of 21, youll have to wait and vote for him

November 30 2011 at 11:57 AM Report abuse rate up rate down Reply
Ray Scarth

Now hold on all of you, let's not have a civil war here(we' ve been down that road once!)

Let's get up to speed here, haven't you been reading the newspaper(or looking at the pictures!).
It's not he Democrats or the Republicans, they all work for the same boss, The machine, big money!
They throw the ball back and forth and your heads follow!
Try following the money!!!!!!!!!!!!!!!!!!!!!!!

November 30 2011 at 11:56 AM Report abuse +1 rate up rate down Reply
scottee

how do you tell if a country is drowning in debt?

November 30 2011 at 7:44 AM Report abuse -2 rate up rate down Reply
jkennedy806

What crap, yes, according to the general accounting standards board this is college accounting 101 and some intermediate accounting for corporate finance as well. Albeit, when I look at the stockholder's perspectus how many debts are outstanding in the portfolio. Corporations like Enron, Merril Lynch AIG, American Airlines (now) hide their debt asset ratio's with liquidity labels that have no direct defining attribute. It's a great game of poker, some can bluff their way thru, in the case of MF Global you have a whole bunch of jokers. And the Wall Street casino has the chips stacked against you. All companies who are over -leveraged are debt sinking. Here is how you can tell. Ask an employee of the company you are thinking of dumping money into. If the employee is a happy camper and making a great wage, good and adequate benefits then there is a good chance the company is doing fairly well. If the employee is over worked, short staffed, needs supplies, has out dated computers and programs I would suspect the company is cash strapped and needs some debt management. Don't rely on the glossy magazine that shows smiling executives -- go to the grunts on the line.

November 29 2011 at 4:33 PM Report abuse rate up rate down Reply
The Schneiders

Its my opinion that no business should get handouts either big or small. If you own/operate a business you should be soley responsible for that businesses finances. Not me! Why should the goverment "aka Me!" give anyone a dime to keep the business in the black. It just doesnt make sense. Perhaps if I didn't have to support major banks; I could use that money to keep my check book a bit further in the black. Just sayin! Personally accountability & common sense have been lost in this country.

November 29 2011 at 3:47 PM Report abuse +1 rate up rate down Reply
3 replies to The Schneiders's comment