How to Tell If a Company Is Drowning in Debt
byNov 29th 2011 1:00PM
Today 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.
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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.