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business newsCan a Company Be Worthless? The Debt Ratio Shows You How
A company's current ratio doesn't give you the full picture of its financial health.
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The most popular measurement of working capital is 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, the Hershey Company (HSY) reported the following results for the past five years:
year debt ratio
2005 40
2006 56
2007 61
2008 81
2009 66
The debt ratio more than doubled between 2005 and 2008, and then retreated in the latest year. However, the trend is ominous. At 66, the debt ratio tells you that for every dollar of total capitalization only 34 cents consists of equity, and 66 cents is borrowed money. The ratio is high and the five-year trend is troubling.
An even worse situation is that of Ford Motors (F). The five-year debt ratio was:
year debt ratio
2005 83
2006 106
2007 94
2008 112
2009 106
In 2005, total capitalization consisted of 83 cents in borrowings and only 17 cents in equity. But by 2009, the situation was much worse. Total capitalization consisted of $1.06 in debt and $-0.06 in debt. In other words, the liquidation value of Ford at the end of 2009 was negative. Debt exceeded 100% of total capitalization. Some analysts would claim that this is not significant; but the history of General Motors should be remembered. By the time the company was dissolved and replaced by the federal government’s bailout, its debt ratio was over 200%.
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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