A Deep Dive Into 3D Systems, Part 6: Solvency Ratios

As part of our in-depth look into 3D Systems (DDD 2.42%) and its 50% share price drop so far this year, we're testing the financial health of the company via various ratios. In this installment, we'll look at the solvency ratios that help reveal 3D Systems' overall financial health, and see whether investors should be worried about the company's debt situation.(Hint: If bankruptcy in the immediate future is your worry, you can breathe a bit easier.)

Why do ratio analysis?
As we covered in the previous installment, ratios summarize the sometimes-overwhelming numbers of the financial statements into a way of looking at the company that lets investors more quickly grasp and understand what's going on.

Ratios also let investors compare a company with its peers at a given point in time, and over time, which can help you spot patterns and trends.

Here's a quick reminder. Always use ratios as part of a larger analysis, rather than taking them in isolation. Using a single ratio, such as P/E or debt-to-equity, to make judgments about a company is worse than using no ratios at all. It can present a distorted view, and therefore investors should always use a variety.

Solvency ratios
Three ratios can help you figure out whether a company is headed into financial difficulty: debt-to-equity (D/E), financial leverage, and interest coverage.

• D/E = total debt / total shareholder equity

Two (primary) sources of capital can be used to fund operations: debt and equity. The latter includes both the cash paid to the company for its shares, as well as its retained earnings over the years. Very often, when a company is first starting out, it runs at a loss, which means retained earnings (earnings not paid out as dividends, but reinvested into the business) start out negative. Over time, however, retained earnings will grow and become a major part of equity.

In a bankruptcy, the debtholders have dibs on being paid from any assets the company might have, which means shareholders (equity holders) generally end up with zip. Too much debt means there's a higher risk of bankruptcy, and either equity holders won't want to own shares or will demand a higher rate of return to compensate them for that extra risk. A D/E ratio of 1.0 means 50% of the capital is from debt and 50% is from equity. Depending on the industry, a lower D/E is better. I get nervous when debt exceeds equity, because the company is getting pretty leveraged.

• Financial leverage = average total assets / average total equity

This is a measure of how many of the assets are funded by debt compared with equity. If the company had no debt, then the ratio would be close to 1. The higher the ratio, the more debt is being used to build the business.

• Interest coverage = EBIT / interest expense

Interest coverage is how well the company can handle paying interest on its debt out of operating earnings (EBIT, or earnings before interest and taxes). This needs to be higher than 1; the higher, the better.

Please note that different industries will have different normal ranges for D/E and financial leverage. A capital-intensive business like a heavy manufacturer or utility generally has higher ratios than a capital-light business such as a software seller.

Here's what the data says
As before, we'll compare 3D Systems with another 3-D printing company -- Stratasys (SSYS 1.87%) -- and with Cisco Systems (CSCO 0.08%), a well-established high tech company.

Source: S&P Capital IQ and author calculation.

If nothing else, investors in 3D Systems have absolutely nothing to fear about debt. The company has essentially none. Back in 2011, when the D/E ratio peaked, it had $138.9 million in debt. But 3D Systems quickly paid that off, and as of the end of 2013, it had only $18.9 million remaining, with no change since then. This also translates into a huge interest rate coverage ratio. Last year, it recorded only $3.4 million in interest expense, compared with more than $12 million in 2012 (which is reflected in the lower ratio that year).

Stratasys has no debt and hasn't for the five years viewed. No issues.

Cisco runs with a higher D/E ratio than I expected, for what is commonly accepted as a high-tech company and thus presumably asset-light. However, that is probably due to a conscious choice by management to target a specific capital structure. Debt generally costs a company less than equity. Thus, by keeping some debt going, Cisco lowers its weighted average cost of capital; compared with a company with no debt, it can earn a lower return on capital while still adding value.

Conclusion
This analysis doesn't raise any yellow flags for me. None of the companies uses an excessive amount of debt, and I'm pleased to see that 3D Systems paid off the majority of the debt it issued a few years ago fairly quickly. The company might consider adding some leverage, however, to optimize its capital structure a bit more, similar to what I believe Cisco has done.

Next up are the ratios Wall Street pays the most attention to, the profitability ratios. Looking at these over time, we see a big reason 3D Systems shares have fallen so hard.

In the next article, we'll look at the profitability ratios and see what's happening with operating and net profit, especially with gross profit going up. It's not exactly pretty.

As each article is published, you'll be able to find them by clicking here.