Judging debt levels

[Concasto]

What metrics do you guys use when judging the debt load of a company? Yes, things like dividend and earnings growth are important, but I feel they are only half the picture. Thanks for any comments.

[Dividend Watcher]

Concasto, sorry to take so long to reply. It's been a busy past week, including the weekend, and have just popped in here every once in a while.

Good question and especially cogent when the economy is in a downswing. There are several things I look at when evaluating a company.

The first thing I look at is the current ratio which is not entirely debt. Basically, current ratio is the ratio of current assets/current liabilities. Current assets can include things like accounts receivable, cash & short term securities, trade credits, short term (under 1 year) licenses of intellectual property and finished inventory. Current liabilities includes things like short-term loans or lines of credit, accounts payable, some accrued taxes and the current portion of long-term debt. I like to see it above 1.5 and the higher the better. However, some companies seem to operate perpetually with it under 1.0. GIS is a good example, their current ratio has been below 1.0 for most of the past decade yet they still pay their bills and raise the dividend. P&G seems to be the same.

Secondly, I like to look at the coverage ratio. This is EBIT (earnings before interest and taxes)/current year's interest payment. You may have to dig for some of this information. I prefer this above 2x but some people think 1.5 is an acceptable lower limit. Something I glance at if it's a low number is whether interest & dividends are covered by earnings. You can infer this by the payout ratio also since interest paid is deducted before you get net profit. This becomes important if free cash flow is lower than reported GAAP earnings.

Lastly, I look at long-term debt. I like to see debt/equity below 80%. This translates to approximately 40% debt/total capital. This isn't a hard & fast rule for me since there are many reasons companies use debt. One caution is to look at equity. Some companies have little equity for a variety of reasons -- especially tangible equity -- which can throw this metric off. What I like to see is LT debt stable or going down unless there is some major new undertaking the company has explained. Also, look at other companies in the same line of business. Are they running similar levels of debt? For example, capital intensive industries such as auto manufacturers, utilities and telecoms typically carry a big debt load. Look at free cash flow for a different perspective on the ability to handle that debt.

As you look at more company financials, you should get a handle on whether something looks fishy. Some companies can handle large debt loads fine. Others it clearly impacts their ability to grow.

For me, debt levels are more gut feeling than hard and fast rules. I place more emphasis on current ratio and interest coverage. LT debt can always be rolled over or refinanced if interest rates are in their favor.

I hope others chime in with their metrics or criteria.

[hendi_alex]

When evaluating property REITs, it is useful to look at maturity date of debt. When too much debt comes due at the same time, especially in the very near future, that represents a possible red flag to me. Also of interest to me, is whether the debt is fixed rate or variable.

[Dividend Gamer]

I like finviz.com

Some metrics I run, and then change a couple key things based on what I may be missing due to rounding error are:

P/B under 10
div: usually over 2% yield and div growth usually over 7%
forward p/e over 20
ROE over 15%

low debt

three year EPS growth > 5%
payout ratio < 65%

I like companies that consistently raise dividends for a minimum of 5 years, usually 10.

[KenBob]

I adjust the yield level of stocks to reflect the debt level.

Adjusted yield = dividend/(price + debt per share)

This is equivalent to assuming that all the debt is converted to stock.