If Americans learned anything from the financial crisis, it’s that the unwise use of debt can destroy wealth in a hurry. This isn’t just true for banks and homeowners, but for all publicly traded stocks, too.
Philosophically, there is nothing wrong with debt. Big-ticket items often are out of reach for businesses and consumers without some form of borrowing. But a company that has borrowed more than it can repay is just as dangerous an investment as a company that can’t turn a penny of profits.
Luckily, there is a very simple screen you can run to find the amount of debt outstanding for a given company — and equally important, the value of its current assets and any cash it has saved up in the bank.
Let’s take a look at McDonald’s (NYSE:MCD) again. Use the Google Finance navigation we have explored before by inputting the company’s ticker then clicking “Financials,” “Balance Sheet” and “Quarterly Data” in succession.
Front and center is the info you’re looking for — graphically represented in an easy-to-read chart. There are bars for debt, bars for assets and even a link showing you the ratio between the two.
But as with so many other things, you should look at the raw numbers so you can make a qualitative judgment as well as a quantitative one.
So now, scroll down the balance sheet in Google Finance and look for these fields:
Cash & Equivalents: Cold, hard currency in the bank.
Short Term Investments: Liquid assets that are as good as cash.
Long Term Investments: Resources that might not be immediately accessible, but are indeed marketable assets.
Total Assets: What the entire kit and caboodle would be worth, including proceeds from the sale of factory gear or the land its offices are on.
Total Current Liabilities: Liabilities like lawsuit settlements or other obligations are as good as debts, since they are bills that must be paid.
Total Long Term Debt: Obligations owed to banks or bond investors that must be repaid over the coming years.
Total Debt: This figure includes any other short-term financing or lines of credit that wouldn’t be classified as long-term debts.
At a glance, the chart at the top tells you everything you need to know. The roughly $33 billion from the “Total Assets” line item and roughly $12 billion in debt from the “Total Debt” line item are shown clearly in the bar graph at the top of Google Finance — as is the approximate debt-to-equity ratio of 36% ($12 billion divided by $33 billion). (Yes, equity is just a synonym for assets).
But it is always worth looking into the details to see if anything stands out — a particularly large hoard of cash, for instance, or a particularly troubling amount of liabilities.
Good Debt vs. Bad Debt
What’s the ideal metric for debt? Well, like price-to-earnings ratios, it can vary widely by industry. Tech stocks typically don’t have a lot of equity in their operations because lines of code in software programs aren’t exactly “assets.” Start-ups can be as simple as a bunch of smart guys with an Internet connection. Conversely, automakers demand a huge level of capital to buy raw materials and invest in machinery — so tens of billions of dollars in debt is not uncommon.
The answer then, is to do as we did for P/E compare apples to apples. Pick a competitor and compare, understanding that different sectors have different limitations.
But obviously, less debt is better than more debt. A good rule of thumb is that if a company is creeping up on a 50% debt-to-equity ratio, it’s time to get worried. Some companies can maintain that level without a problem — but keep in mind that high levels of debt also demand high levels of debt service payments. In other words, a corporation pays more in interest to lenders, so it has less capital to spend on growing the business or delivering shareholder value through dividends and stock buybacks.
And of course, always remember that the inherent reason a company must declare bankruptcy is because it can’t pay its debts anymore. Plenty of corporations lose money for years without ever disappearing, but ultimately running up unpayable debts is what drives businesses into Chapter 11 bankruptcy.
Take Kodak, which had a debt-to-equity ratio of roughly 100% early last year — meaning every penny of the company’s value was already borrowed against. It was no surprise to see the company declare bankruptcy soon after.
This is a slippery metric, to be sure. But if you find a company with almost no debt or with a huge amount of cash on the books, it is a decidedly positive sign, showing the company has potential.
Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.
Also, for just 99 cents you can download Jeff’s e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”
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