Unlocking Hidden Debt

I read a lot of misstatements in the financial press about debt levels, or lack thereof. Statements like "company ABC has a pristine balance sheet with no debt" make me cringe, because I know that although the writer probably graduated at the top of his or her class in journalism, he or she most likely didn't study how to read a financial statement.

Hidden debt is most prevalent with multi-unit operators like retailers and restaurant companies. For these businesses, the greatest source of indebtedness usually isn't even on the balance sheet. It's operating leases, and understanding this can completely change the way you assess the level of financial risk inherent in the company's business. It's kind of like those candies that come in fancy boxes with tissue paper. They all look tasty, but you don't know what you're getting until you bite into one.

Operating leases for retailers come about because very few of them own the land and buildings they do business in. For mall retailers, it's a given that they don't own the space. The mall does, and the retailers just pay rent. But even stand-alone retailers usually rent the land and the building from a developer. In some cases, just about everything in the building is leased. Usually they'll be operating leases, which means that at the end of the lease term, the assets all go back to the lessor (the landlord). GAAP (generally accepted accounting principles) doesn't count them as assets because the lessee (the guy who pays the rent) doesn't own them. Therefore, they don't show up on the balance sheet, which makes it hard to tell how leveraged most retailers are without some additional information.

Here's an example of how misleading this can be. Take the debt information published on almost any financial website and apply it to some retailers. I chose five companies for illustration purposes: Wal-Mart (NYSE:WMT), Best Buy (NYSE:BBY), Target (NYSE:TGT), Bed Bath & Beyond (NASDAQ:BBBY), and The Gap (NYSE:GPS). Here's the kind of picture you will get:

Looks pretty clear, doesn't it? Bed Bath & Beyond is conservatively leveraged with no debt, and Target is way out there with tons of leverage. Not true, my friends, or at least this is only part of the picture.

At this point, you may be asking whether operating leases are really debt. The answer is yes, but it's hidden debt. Rating agencies like Standard & Poor's and Moody's don't even look at traditional debt-to-equity ratios. They go beyond the balance sheet to calculate two key measures of the debt levels of a company, and the company's ability to service that debt.

Adjusted debt to adjusted capitalization
This measure adds up all of the debt, including the hidden debt from the operating leases, and subtracts the cash on hand to get a better picture of the true leverage of the company. Within the calculation, ratings agencies multiply operating rents by eight to account for all of the lease costs in order to approximate the amount of debt these leases represent. A retailer may have hundreds or thousands of leases, all with different end dates, escalations, renewal clauses, etc. It's simpler and reasonably accurate to take prior-year operating rent times eight.

This picture looks very different. It turns out that when you consider all debt, including operating leases, Gap has the most debt as a percentage of its total capitalization, with Bed Bath & Beyond the second highest. Target looks much more reasonable, right in the same space as Wal-Mart.

Fixed-charge coverage
All of this helps to clear up total debt levels, but it doesn't answer the question of the company's ability to service that debt. For that, you need to look at fixed-charge coverage, which measures how much leeway a company has to make debt payments as they come due. This is even more interesting.

Now you see these companies the way the rating agencies look at them. A peculiarity to note is that interest is added back to the numerator. That's because you want to see coverage before interest is paid.

At the bottom, you can see the current S&P credit ratings for each company. Because Wal-Mart has the most coverage of fixed charges, it has the highest credit rating at AA. Gap has the lowest credit rating at BBB- because it has the lowest fixed-charge coverage. The rating agencies will consider other factors in determining credit ratings, such as management strength and consistent operating history, but these are the two primary numerical factors driving the credit ratings.

This is not to say that any of these companies are approaching leverage difficulties. All of them are rated BBB or higher, which means investment grade. But if you're one of those people who wants to understand how leveraged a company is before you buy its stock, you should not ignore operating leases. Where do you find out about them? Check the "Notes to Financial Statements" under leases in the annual report. What you find may surprise you.

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Fool contributor Timothy M. Otte is one of those weird people who actually reads the "notes to financial statements." Hey, it takes all types. He owns shares of Wal-Mart but none of the other companies mentioned in this article. The Fool has a disclosure policy.