Stock pickers typically want to own a company with a fortress balance sheet, not a flimsy one. This financial statement is worth looking at in order to decide whether to buy a new stock or keep the ones you own.
It provides a snapshot of a company’s financial health at a particular point in time, typically at the end of the quarter. Tage Tracy, the author of How to Read a Financial Report, says investors who understand a balance sheet can more easily see where a company may be weaker than its management claims. And yet, says Tracy, “the balance sheet is often overlooked.”
First things first. Why is it called a balance sheet? Because it lists a company’s assets “balanced” against its liabilities plus its shareholders’ equity — essentially, reflecting what the business has compared with how it was funded. The two sides always equal out.
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There’s a wealth of information to be gleaned for those who look closely. A quick peek at debt levels isn’t enough. How much cash is there to offset the company’s obligations? How does the debt compare with the company’s earnings? How easy is it for the company to make the annual interest payments?
The answers to these questions (and more) can help you weed out the sickly from the healthy.
We’ll tell you what matters most and how to find it or calculate it. We used data supplied by S&P Global Market Intelligence, but you can find corporate balance sheets and other financial statements on a number of websites, included as part of a company’s earnings reports and on file at the Securities and Exchange Commission.
Balance sheet and other data here are as of August 31, except where noted.
Total debt
A company’s total debt includes not only bank loans and other debt but also leases for land, buildings and equipment, as well as other obligations. Net debt takes into account how much cash and liquid, cash-like investments the company is sitting on. After all, if they wanted to, executives could just make a withdrawal and pay off a chunk of what the company owes, right?
It can make a big difference. Consider Microsoft (MSFT): It had $112 billion in total debt as of June 30, but nearly $95 billion in cash and investments. Net debt was a much more palatable $17 billion.
If a company has more cash than total debt — as Alphabet (GOOG), Nvidia (NVDA) and Apple (AAPL) do, by the tens of billions of dollars — net debt is actually a negative (and excellent) number.
Debt load or overload?
It’s important to get an idea of how easy it is for a company to pay back its debt. That’s where various debt-to-earnings metrics come in. (Earnings data come from the income statement, published with the balance sheet.)
Simply take the debt number — total or net — and divide it by profits for the past 12 months. The result tells you how many years of earnings it will take to pay back all the debt. “Needless to say, the higher that ratio is, the more financial risk is present in the company,” Tracy says.
In many cases, analysts choose to divide by EBITDA, or earnings before interest, taxes, depreciation and amortization. They like this stripped-down number because it’s a rough approximation of income generated strictly from the operations of the business. Though not an item on income statements, companies often calculate EBITDA for earnings presentations.
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Sometimes, analysts looking at industries that need to spend a lot on equipment subtract capital expenditures from profits. (Find cap-ex numbers in the cash-flow statement, published with other financial statements.) After all, money spent maintaining and building a business isn’t available to pay off debt.
Railroad operator Norfolk Southern (NSC), for example, had a net-debt-to-EBITDA ratio of 2.6. But net debt was 7.1 times the amount of EBITDA minus capital expenditures.
Interest-coverage ratio
Bigger is better for another ratio that measures a company’s ability to handle borrowings. Dividing EBITDA by a company’s annual interest expense (found on the income statement) is known as the interest-coverage ratio.
It can also be calculated with EBIT, or earnings before interest and taxes. The ratio gives a sense of how many years’ worth of interest a company can pay with just one year of profits.
Looking again at casinos, we see that Caesars Entertainment and Wynn Resorts recently had interest coverage ratios of 1.6 and 2.8 — the two smallest numbers among all consumer discretionary stocks in the S&P 500. This, together with the debt ratio numbers discussed above, suggests their balance sheets are strained.
Las Vegas Sands, which looked pretty good before, has an interest coverage ratio of 5.5 — better than its peers, but still below the 10.7 median number for all S&P 500 companies. MGM Resorts, however, can cover 10.8 years’ worth of interest expense with its EBITDA, a much better situation than the debt ratio discussed above had implied.
The lesson: It pays to look through different lenses, and investors picking casino stocks or any other stock should use these numbers to dig deeper into the companies’ businesses.
Debt vs equity
A ratio of debt to equity is calculated by dividing total debt by the amount of shareholders’ equity, found near the bottom of the balance sheet. Shareholders’ equity is an approximation of stockholders’ stake in the company.
The debt-to-equity ratio says a lot about how much debt a company has chosen to use. And that, in turn, tells you how vulnerable it can be if its business turns bad or the economy goes south.
Costco, by contrast, had about $8 billion in total debt and $27 billion in equity, for a ratio of 0.3. And you can’t even calculate a debt-to-equity ratio when you figure in Costco’s $14 billion in cash, which gives it negative net debt and puts it in even better shape.
Admittedly, poring over a balance sheet to parse a company’s debt this finely takes a little extra work. But in corporate finances, just as in family finances, managing debt is of paramount importance.
Says Tracy: “If you remember the Great Recession from 2007 through 2009, the businesses that did not have a strong balance sheet were more susceptible to literally going out of business.”
Note: This item first appeared in Kiplinger Personal Finance Magazine, a monthly, trustworthy source of advice and guidance. Subscribe to help you make more money and keep more of the money you make here.
