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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • The Importance Of The Debt Ratio 0 comments
    Jan 13, 2014 5:57 PM

    Some analysts rely on the current ratio to judge a company's cash management; however, this could mislead rather than enlighten.

    The current ratio is derived by dividing current assets by current liabilities. The balance of these assets equals liquid assets, in the form of cash or convertible to cash within one year (accounts receivable, inventory, marketable securities, for example). Current liabilities are those debts payable within one year. The problem in relying on this is that it can be easily manipulated. The ideal of 1 (meaning the two sides are approximately equal) can be created before the end of the year. For example, a company reports (in millions of dollars) current assets of $415 and current liabilities of $705. That is a current ratio of 0.6. However, the company could borrow $350 million and simply hold proceeds in cash. That takes current assets up to $765 and adjusts current ratio to 1.1 ($765 / $705).

    Borrowing funds to affect the ratio is misleading. An alternative test of working capital is the debt ratio. This ratio compares debt to total capitalization. The value of total capitalization is long-term debt plus shareholders' equity. The debt ratio is calculated by dividing long-term debt by the total. For example, a company reports long-term debt at $845 million and shareholders' equity at $3.4 billion. Thus, total capitalization is $4.245 (0.845 + $3.4). The debt ratio is 19.9 (this is a percentage, but it is reported as a number with one decimal and no percentage signs) - 0.845 / 3.4 = 19.9.

    By tracking year-end debt ratio over several years, you can discover the level as well as the trend in the debt ratio. If this ratio is increasing, it means less capital available for the future payment of dividends or to fund growth. If the debt ratio is level, that's a sign that management is keeping long-term debt in check. If the ratio is falling, that's even better.

    To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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