The last post showed you how simple balance sheets can be. Now we are going to examine a bit further into another important balance sheet equation, as well as a couple of examples to see if we can understand every last detail. If you haven’t seen part 1 of this post, be sure you check it out.
So the first thing to understand is that balance sheets will differ from industry to industry. The balance sheet of an insurance company, for example, will vary in the line items from one of a retailer. Their business models are just so different.
But there are 3 important line items that every single balance sheet shares. It’s really the only 3 categories I’ll look at when I am analyzing and comparing stocks. Those 3 are:
1. Total Assets
2. Total Liabilities
3. Shareholder’s Equity
If you were paying attention, these are the same 3 I talked about in Part 1: Simple Balance Sheet Analysis. So of course, we have to know about them because they add up all of the other rows of the balance sheet.
Assets are pretty self explanatory. They are anything that the company owns that has value, and that can be sold for cash. Think of things like inventory, real estate, and even just straight up cash. Yes cash is an asset.
Liabilities are anything that the company owes. Whether that’s short term or long term debt, or accounts payable. Anything that a company is financially responsible for goes in the liabilities section.
Finally we have shareholder’s equity. It’s called shareholder’s equity for a reason, because it is the equity that shareholders are entitled to. Like I mentioned in part 1, this is one of our golden eggs. It’s a very tangible way to see how much value we are getting in a stock.
Balance Sheet Equation
Now I already explained how we can use the P/B (or price-to-book) ratio to find value in the balance sheet with the part 1 post. But there’s another helpful balance sheet equation that we can use to evaluate companies.
This ratio helps us minimize risk. Period. Companies with more debt are more risky, it’s so simple yet so many people forget it. But it’s not just total debt numbers. Instead, it’s all about how much debt does a company have compared to its assets and equity? If we had a way to find this out, we could avoid the riskier companies. [I talk about this in my 7 Steps to Understanding the Stock Market guide].
Debt to Equity ratio tells us exactly this. There’s several ways to calculate Debt to Equity ratio, but I like to use the simplest version. It’s the most useful because it covers our backside in case of strange accounting gimmicks. I use this balance sheet equation:
Debt to Equity = (Total Liabilities) / (Shareholder’s Equity)
Some people just use short term debt to calculate this value, but why do that? Don’t we want to know all of a company’s debt? What if they are just stacking all their debt short term, or long term?
A simplified equation like this one prevents us from getting blindsided by an accounting trick. And it lets us see the whole picture, and get a consistent ratio throughout all companies (this is because the GAAP accounting rules of the U.S. require every company to submit total assets, liabilities, and shareholder’s equity numbers).
As a general rule of thumb we always want a company that has a Debt to Equity of less than 1. Why? It makes sense when you think about… any company with a debt to equity over 1 has more debt than their equity. So if all their debt was called tomorrow, they’d be bankrupt. Is that a situation you want to get in to?
Of course, we are talking about extreme and worst case scenarios, but who really would’ve thought that a big bank like Lehman Brothers would’ve failed? I’d prefer to be safe rather than sorry, and I think you should be too.
Now the one caveat to the debt to equity rule is that many financial companies keep their debt to equity ratios around 10. So they are about 10 times more leveraged than the average company (with a debt to equity around 1). Financial companies are banks and insurance companies.
But just because all the cool kids are doing it, doesn’t mean we should just blindly follow the blind. For example in the insurance industry, I’ve found several companies with much lower debt to equity ratios than 10. All trading in the S&P 500. Don’t be afraid to turn over more rocks.
Proof about Debt to Equity
I realize I can tell you on and on about how good debt to equity ratio is. But it’s better to just show you. So here you go.
Check it out, the debt to equity for several recent big name bankruptcies: [click to continue…]