Many times, pure numbers or financial metrics are taken at face value without a second thought. While useful and for the most part relatively accurate, sometimes financially-strong companies can get a bad rap from some investors because of a metric or number that's been distorted by profitable financing activities.
The debt-to-equity ratio and solvency
Firms with an attractive balance sheet will ideally have a low debt-to-equity ratio, whereas companies with a debt/equity ratio over 1 are often avoided by many investors. Of course, there's an exception for banks and financials that "borrow money to make money" and therefore will more often than not have debt/equity ratios higher than 1.
Another exception that should be made, but often isn't, is for companies that have financing divisions. Two examples of this can be demonstrated by Ford Motor Company (NYSE:F) and IBM Corp. (NYSE:IBM).
As can be seen, simply judging these two companies by the debt/equity ratio would tell us that both firms are likely in poor financial shape and possibly even insolvent.
Facilitating growth with financing
Ford's balance sheet carries a very large amount of debt. Should this worry investors?
This depends, as some will argue "debt is debt". Ford, however, attributes most of its debt to Ford Credit, which contributed a pre-tax profit of $434 million during the company's most recent quarter.
It could be argued, therefore, that the debt originated by Ford Credit is actually "good debt", because it adds to the bottom line and is primarily backed by a physical asset such as an automobile that can be recovered in a worst-case scenario. This makes the debt less risky credit-wise as well. This division can also lend to the Ford Automotive division at wholesale rates.
Ford ended its last quarter with Automotive gross cash of $25.8 billion. This exceeded Automotive debt by $10.4 billion. Distinguishing between "bad" automotive debt and debt originated from financing activities gives a much more accurate picture of the automaker's financial condition, and also shows that its balance sheet is much stronger than it initially appears. The company is also very liquid, with a current ratio of 1.72.
Big Blue and financing
Like Ford, IBM also has a division that distorts its perceived debt levels.
IBM's Global Financing Segment, or IGF, was responsible for $29 billion of the firm's debt as of its most recent quarter. This segment is used to finance credit-qualified customers who want more cost-effective ways to acquire services from IBM. Backing this segment's debt out, the company's non-financing debt-to-capital is roughly 56%.
Revenues for the segment increased 4%, with pre-tax income increasing 8% to $504 million in the company's recent second quarter. While this doesn't add a very significant amount to the company's overall bottom and top lines, it certainly isn't detrimental, either. This segment also has very attractive gross margins, equaling 54.8% as of June 30 when IBM last reported. The company is also relatively liquid, with a current ratio of 1.14.
The bottom line
Not all debt can be said to be an inhibitor to a company's growth and/or financial health. While an unusually high amount of debt on a company's balance sheet (or a high debt-to-equity ratio) is often alarming at first, it pays to dig a little deeper and analyze what type of debt is being carried by the company in question.
Financing segments and divisions can utilize leverage to generate earnings and facilitate top line growth as well. As long as it's utilized wisely, companies such as Ford and IBM can use it responsibly for growth, while also maintaining strong balance sheets and ample liquidity.
Disclosure: The author is long F, WFC, JPM.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Articles I write for Seeking Alpha represent my own personal opinion and should not be taken as professional investment advice. I am not a registered financial adviser. Due diligence and/or consultation with your investment adviser should be undertaken before making any financial decisions, as these decisions are an individual's personal responsibility