While I acknowledge that most investors look at a company on a going concern basis and therefore do not necessarily have to know the "true" value of the assets, it is still important to watch for a potentially inflated asset base. This, of course, raises the question of the actual value of a company's assets in the event of bankruptcy - a question that is difficult (impossible?) to answer ex ante. A ratio greater than 1 means that a company has more liabilities than assets and is typically very inflexible in an economic downturn and increasingly at the mercy of its creditors (i.e., an increased risk of insolvency).įigure 1: Comparison of a balance sheet with a low debt to assets ratio (left) and a high debt to assets ratio (right) (own work)Ĭonversely, the higher the debt to assets ratio, the lower the loss absorption capacity and the higher the theoretical probability that there will not be enough left over to satisfy the claims of suppliers, pensioners, bondholders, shareholders and other stakeholders in the event of bankruptcy. All other things being equal, a company with a low debt to assets ratio has a high loss-absorbing capacity (see below). In general, a low debt to assets ratio indicates conservative management because a relatively high proportion of assets are financed by equity (Figure 1), which has no contractual right to interest payments, making the company more financially robust in a downturn. In my view, given the simplicity of the approach, investors should take the time to look at the balance sheet and calculate the ratios themselves or stick with a single source. However, investors should be careful not to compare debt to asset or debt to capital ratios from different sources, and it is important to know what is included in debt and capital. The debt to capital ratio can be viewed as a variant of the debt to assets ratio, since "capital" includes both debt and equity. In general, subtracting equity from total assets yields the most conservative version of the ratio because it implicitly takes into account all liabilities. Sometimes only funded debt is considered. ![]() "Debt" refers to all of a company's liabilities, such as interest-bearing debt and other liabilities, but definitions vary. This is a straightforward ratio that puts debt in relation to a company's total assets, and is sometimes also referred to as the gearing ratio. Don't worry, no mathematical equations are used, and in fact, my preferred metrics can be explained in a sentence or two and provide illustrative results. In this article, I will discuss the most common leverage ratios - how they are defined, when they should be used, and when they can produce misleading results. However, some of the more or less commonly available ratios can easily be misinterpreted, leading to false positives or, probably worse, false negatives. The devil is in the details, and it is important to take a close look at a company's debt using a number of metrics. On the surface, this looks like a pretty bad setup in an environment where interest rates are likely to remain high for a significant period of time. I've probably looked at more than 100 companies in the last two years and rarely have I seen one that hasn't increased its debt to a more or less significant degree. ( HD ) bought back $14.8 billion worth of stock at an average price of $388), and some companies would quickly cease to exist without a steady infusion of capital. ( VFC ) purchased fashion label Supreme for 3.7 times sales), shares are being bought back at all-time highs (e.g., The Home Depot, Inc. Companies are being acquired at ridiculous valuations (e.g., V.F. Debt is not a bad thing per se, but with extremely low interest rates, malinvestments are increasingly common. Companies are facing a higher cost of capital, which puts them at risk especially those who succumbed to the siren songs and took on excessive debt. What was unthinkable three years ago is now a reality, and it increasingly looks as if the days of "easy money" are finally over. ![]() Over the course of about 15 months, the federal funds rate was raised to 5.25%, a level not seen since the Great Recession. Artoleshko/iStock via Getty Images IntroductionĬoming out of the pandemic, the Federal Reserve raised interest rates at an unprecedented pace.
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