A company's working capital defines its ability to generate cash. This is used to fund current operations (pay bills), give stockholders dividends, and pay for future growth. But is a company really solvent? The debt ratio can reveal when a company is, in fact, worthless.
The most popular measurement of working capital is called the current ratio. Current assets (cash or assets convertible to cash within 12 months) are divided by current liabilities (debts payable in the next 12 months), and the result should be at '1' or higher in a healthy company. But the current ratio does not tell the whole story.
The debt ratio is the percentage of total capitalization represented by borrowings. A company creates capitalization through equity (stock) and debt (notes and bonds that have to be repaid). So if a company's total capitalization consists of equal shares of equity and debt, its debt ratio is 50 (or, 50%, because debt is one-half of total capitalization). But what if debt is much higher?
For example, Praxair (NYSE:PX) reported the following results for the past five years:
The debt ratio rose over 5 years; this means that for every dollar of total capitalization, in 2012, about half came from borrowings and the other half represented equity. If this continues to rise, it could spell long-term weakness for the company. You would prefer to see the debt ratio decline over time.
For example, Stanley Black & Decker (NYSE:SWK) reported its five-year debt ratio as:
Even with some back and forth, the long-term trend here is a decline in the ratio. This is a more promising signal. As of 2012, about 34 cents of every dollar of capitalization came from borrowings, whereas 66 cents represented equity.
The debt ratio is not only significant in terms of how debt and equity are compared each year, but more so in the trend itself. When you see a company's debt ratio climbing every year, it means management is relying more and more on borrowed money, meaning future earnings will have to go increasingly to repayments and interest, and less to shareholder dividends or expansion of business. Although the current ratio is a popular test of working capital, it does not tell you when a company is worthless. For example, during the five years when Hershey's debt ratio increased so much, its current ratio improved every year. Only the debt ratio and its trend can show you when a company's working capital policies are starting to deteriorate.
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