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Topic: How To Invest

Investor Toolkit: Use the right financial ratios to assess debt risk

Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice, including how to use financial ratios. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Use the right financial ratios to assess debt risk”

Many successful investors start researching a company by looking at its financial ratios, including its debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.

A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.

How Successful Investors Get RICH

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Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course).

But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by cutting them or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

Financial ratios: Debt-to-market cap gives you a better sense of a company’s staying power

Instead of focusing on debt-to-equity financial ratios exclusively, we recommend that you also look at the ratio between a company’s debt and its market capitalization or “market cap” (the value of all shares the company has outstanding).

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

A great example is Coca-Cola Co. (symbol KO on New York). The company has long-term debt of $12.7 billion, which represents a moderately high 39% of its $32.6-billion shareholders’ equity. But that debt is just 8.1% of its market cap.

The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset — its so-called intellectual property. In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar. More important, the Coke brand name carries no value on the company’s balance sheet. However, these are reflected in its huge market cap of $157.2 billion. So, put into perspective, the company’s debt is very low.

In contrast, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. And their debt is low, since no one wants to lend them money.

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