Very often I have come across analysts who provide stock recommendations take about various Qualitative and Quantitative parameters about a company.
They also mention a series of financial metrics to check and one important is Debt to Equity ratio.
This shows the proportion of assets financed with debt and equity. A ratio of 1:1, for example, means that the amount of debt used to finance the assets is same as the equity.
It is considered as a safe measure (any debt to equity ratio of 1 or less than 1) because the total debt is covered by equity.
But, is this a correct approach towards valuing a company’s debt servicing capability? NO in my opinion.
Let us take an example of us purchasing a house for $200,000. Assume we give a downpayment of $50,000 and take the remaining $150,000 as a home loan from the bank.
At this stage, our equity in the house is 25% and debt is 75%. That is, debt to equity ratio is 3:1
Say after 5 years, we have paid back $50,000 to the bank against the loan, and hence the debt has come down to $100,000.
In the meantime, housing market has moved up and the value of the house has gone up from $200,000 to $400,000.
At this stage, our equity in the house is 75% and debt is 25%. That is, debt to equity ratio is 1:3
Can we feel safe that our Debt servicing capability is great as we can cover the debt with the equity in our house? That would mean selling the house and unlocking our equity to settle of the debt with the bank.
Will we feel comfortable liquidating our asset (house in this example) to service the debt?
Our Home loan servicing capability should be measured by our monthly salary or earnings and how can we increase the payment to the bank each month / year, and if we can part pay a portion of the loan with the bank etc.,
Similarly, Debt to Equity ratio of the company is not much of use unless if you are planning to purchase a company at a liquidation stage. In which case assets can be sold off and debt is serviced, and remaining is shared among share holders.
Hence, we should look for better metrics or ratios to evaluate a company’s debt servicing capability like – Debt to Free Cash flow ratio, Debt to Net Profit ratio, Debt to Reserves and Surplus ratio etc.,
Please let me know your thoughts.