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Stingy Investor Tip Sheet

Debt Ratios

I use leverage ratios in several articles but many online stock screeners only provide debt-to-equity ratios (D/E). The two are linked and either can be used in some cases. Let's take a closer look starting with a few definitions.

I'll define leverage as equal to total assets divided by total equity. Debt-to-equity can be calculated several ways. The debt part might be long-term debt or total debt. The equity part might be common shareholder's equity or total shareholder's equity. I'm going to define the debt-to-equity ratio as total debt divided by total equity.

The accounting talk might be a little intimidating, but stay with me. In practice it's not that difficult. Let's look at a real world example. I'm going to focus on Altria's balance sheet from September 30, 2008 as presented by yahoo.com.

Here it is, but keep in mind we're only focusing on a few entries.

Assets
	Current Assets
		Cash And Cash Equivalents	   915,000  
		Net Receivables			    52,000 
		Inventory	 	         1,060,000 
		Other Current Assets 	         1,818,000 
					 	----------
	Total Current Assets		         3,845,000 

	Long Term Investments		         9,673,000  
	Property Plant and Equipment	         2,162,000  
	Goodwill				    81,000  
	Intangible Assets		         3,041,000  
	Other Assets			         1,868,000  
						----------
	Total Assets			        20,670,000  

Liabilities
	Current Liabilities
		Accounts Payable		 6,189,000  
		Short/Current Long Term Debt 	   284,000   
	Total Current Liabilities		 6,473,000  

	Long Term Debt				   601,000  
	Other Liabilities			 3,603,000  
	Deferred Long Term Liability Charges	 5,815,000  	
						----------
	Total Liabilities			16,492,000  

Stockholders' Equity
	Common Stock			    	   935,000  
	Retained Earnings	 	 	22,113,000  
	Treasury Stock			       -24,444,000
	Capital Surplus			  	 6,369,000  
	Other Stockholder Equity	   	  -795,000	
					       -----------
	Total Stockholder Equity	 	 4,178,000  

	(All figures in $1000s)


For our purposes we are interested in 3 figures

Total Assets: 20,670,000 (The sum of all assets)
Total Debt: 16,492,000 (The sum of all liabilities)
Total Equity: 4,178,000 (The sum of all equity)

(Note: Total debt is equal to total liabilities.)

You might notice that total assets happens to be equal total debt plus total equity. It's no coincidence and it's true of all firms. But before exploring the consequences further, let's check out Altria's ratios.

Leverage    =  Total Assets / Total Equity 
            =  20,670,000 / 4,178,000
	    =  4.947 (rounded off)

Debt/Equity = Total Debt / Total Equity
            = 16,492,000 / 4,178,000
            = 3.947 (rounded off)


Generally speaking, firms with lower leverage ratios and lower debt-to-equity ratios are more stable because they have more equity and less debt. Value investors often look for firms that are debt light and have low ratios.

Let's explore the connection between leverage and debt-to-equity ratios. They are connected because total assets equal total debt plus total equity. I'm going to do a little algebra, but it's quick and hopefully painless.

Leverage = Total Assets / Total Equity

	but

	   Total Assets = Total Debt + Total Equity

	so

Leverage = (Total Debt + Total Equity) / Total Equity

Leverage = Total Debt / Total Equity + 1

or

Leverage = Debt/Equity + 1


We can now double check our formula with Altria's ratios.

Debt/Equity = 3.947 (rounded off)
Leverage = 4.947 (rounded off)

It's fairly easy to convert debt-to-equity ratios to leverage ratios provided they're calculated using total debt, total equity, and total assets. If they aren't then there'll be some subtle differences.

Many investors following Graham's Simple Way want to use debt/equity ratios instead of leverage which is fine. Graham's stuck with leverage ratios of less than 2.

Leverage < 2

That's the same as,

Debt/Equity + 1 < 2

or

Debt/Equity < 1

Again, this result requires the use of total debt, total equity, and total assets to calculate the ratios.

I hope this little tutorial on debt ratios wasn't too intense. But I tend to get questions on the two ratios and I'd like to help out less vocal readers who might be scratching their heads in silence.


11/25/2008   11:59 PM EST   Permlink   save & shareLeverage



 
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