We are now up to number 5 in our 10 Things To Look For When Buying A Stock series. Today, we want to take a look at debt. Debt can not only sink the finances of an individual but can sink a corporation as well. Washington Mutual, General Motors, Blockbuster, Kmart, and Lehman Brothers were all forced to file bankruptcy because of too much debt.
What do Apple (AAPL), Research in Motion (RIMM), and Buffalo Wild Wings (BWLD) have in common? All of these companies have no debt on their balance sheets. Warren Buffett loves investing in companies that have little to no debt. Buffett favors companies whose ability to generate cash dwarfs their outstanding debt.
Why does debt matter?
Debt matters because it can reduce shareholder returns and deplete the cash reserves of a company. Also, you can get a good snapshot of a company by looking at the amount of debt on the balance sheet.
Cash Flow to Debt Ratio
Compare the total debt to the cash flows that are generated by the company. This is known as the cash flow to debt ratio. It’s expressed in the formula below.
Cash Flow to Debt Ratio = Operating Cash Flow/Total Debt
The higher the percentage is, the more likely it is that a company can make its debt payments. A high cash flow to debt ratio decreases the risk of a company defaulting on bond and loan payments.
Debt to Equity Ratio
Another way to judge a company’s level of indebtedness is by looking at its debt to equity ratio. This ratio helps you identify exactly how much leverage a company is relying upon. The formula is as follows.
Debt to Equity Ratio = Total Liabilities/Shareholders Equity
A high debt to equity ratio illustrates that a company is relying heavily on debt to finance growth. Companies with high debt to equity ratios are more likely to fall prey to financial difficulties and bankruptcy. That is because they may find it difficult to service their debt load during economic slowdowns.
Follow Buffett’s lead
Look for companies that have a debt to equity ratio below 0.50. Buffett is even more conservative preferring to invest in companies that have a debt to equity ratio that is below 0.30. Buffett likes to see companies that can grow earning using equity and not large amounts of debt.
It’s important to note that some industries require using debt to finance expansion because they are very capital intensive. In these situations look for companies whose debt ratios are lower than competitors. You have to be careful about investing in companies whose debt to equity ratio is much higher than industry peers.