The Dangers of Debt: Evaluating Capital Structure

One lesson that could have been learned from the market problems of 2008 was that too much debt can be dangerous. Over the recent market rises, many firms have started back down the familiar path of being highly leveraged by taking on debt to finance more growth. This can be dangerous, and as an investor you should know how to evaluate this.

Feb 7, 2014 at 3:05PM

As in informed investor, understanding a company's capital structure is an important step to evaluating its future prospects and stock performance over the long term. Companies using debt to finance growth isn't necessarily a bad thing in itself, and the amount of debt that is "normal" is partially dependent on the industry that the company operates in. Generally speaking, however, less debt is usually better than more and companies that have more equity over debt generally have less risk. 

Capital structure and future growth
If a company has a heavily debt-leveraged financial structure, there is risk that if business slows down or a wider economic downturn occurs then the company will be crushed under the weight of trying to repay these obligations. Sound familiar? Think of the companies that were ruined in the wake of 2008 because they didn't have the financial strength to weather the storm. American Airlines is a great example of a company that leveraged itself too heavily with debt and was ultimately forced to file bankruptcy in 2011 when they were unable to continue operating due to decreased revenues and the inability to pay off their liabilities.

Evaluating debt to equity 
Debt to equity is a fast and easy way to evaluate a company's capital structure and their debt risk. The equation for this ratio is the firm's total debt divided by the firm's total equity. A ratio of one means that the firm is balanced with the same level of debt as equity, whereas zero would mean that it is all equity. Generally speaking, a ratio above two is not a good sign. You can find these numbers directly on a firm's most recent balance sheet.

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A debt to equity of more than 2 should be a red flag. 

If you want an even more accurate ratio, you can make a few adjustments. Short-term liabilities like accounts payable don't provide much info about leverage, so often these are left out of the equation. Only interest-bearing, long-term debt is used. Additionally, some off-balance-sheet liabilities such as unpaid pensions and operating leases should be included as they are still areas of leverage and liquidity risk for the company. 

The good, the bad, and the ugly in today's market
Here are a few examples of companies that are exemplifying these principles now.

The bad: Seaworld (NYSE:SEAS) has a debt-to-equity ratio of 2.6 when calculated directly. When accounts payable are taken out, the company still has a debt to equity ratio of 2.5. This level of debt is extremely dangerous, especially for a company that relies on consumer discretionary income, which is a key area that families cut back on in hard times. In a competitive industry, one with the likes of Disney which operates at a debt/equity ratio of 0.67, this should make Seaworld investors nervous.  

The goodChevron (NYSE:CVX) has a debt-to-equity ratio of just 0.46 once accounts payable are removed. Often a company that has been financed by debt will have a high return on equity (RoE) because its returns are financed by debt. Because equity is in the denominator of the RoE equation, a smaller equity and larger revenues means a better RoE. For Chevron, a revenue last year of $214 billion and low debt still provides a healthy return on equity of over 17%. The company looks good on both metrics and still has a P/E multiple of less than 10.   

Apple (NASDAQ:AAPL) is another company with a strong capital structure. When accounts payable are taken out of the equation, Apple has a debt-to-equity ratio of just 0.38; this means that the company has very low long-term obligations that could drag it down in a negative economy. Because the company has so much cash, over $40 billion of it, there is little fear that the company will ever have issues with either its short-term or long-term debt obligations. 

The Foolish takeaway
While high leverage doesn't automatically make a stock a bad investment, it should raise a red flag and should warrant more research from potential investors. The debt-to-equity ratio is a great way to assess a firms capital structure and to evaluate the risks it faces should the economy slow down or the company's revenues drop. However, this ratio should never be analyzed alone, as other factors could make these numbers look better or worse.

Take these lessons and use them to start investing now
The key is to learn how to turn business insights into portfolio gold by taking your first steps as an investor. Those who wait on the sidelines are missing out on huge gains and putting their financial futures in jeopardy. In our brand-new special report, "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you what you need to get started, and even gives you access to some stocks to buy first. Click here to get your copy today -- it's absolutely free.

 

Fool contributor Bradley Seth McNew has no position in any stocks mentioned. The Motley Fool recommends Apple and Chevron. The Motley Fool owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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