3 ways to evaluate a company's debt level to help judge the risk of buying its stock

Published Sun, Nov 12 202310:01 AM EST

Here's our Club Mailbag email investingclubmailbag@cnbc.com — so you send your questions directly to Jim Cramer and his team of analysts. We can't offer personal investing advice. We will only consider more general questions about the investment process or stocks in the portfolio or related industries. This week's question: If I am evaluating a few companies in one industry. What is one good metric to compare their debt levels? — Gail This is a great question, and there are a few metrics to consider. You are correct to think about debt levels versus peers in the industry — but, be sure to take it a step further. Debt in a vacuum is useless. Instead, we need to think about leverage, meaning we have to consider the debt in relation to assets, profits and/or cash flows. Think about it like this, if say John has a $100,000 of debt in his name, and Jane has $1 million of debt in her name, who is better off? You might think John, after all he only has 10% the debt that Jane has. But what if I then told you that John also only has $50,000 cash in the bank whereas Jane has $2 million cash in the bank? Now we're getting a better picture as we can see that John is far more "leveraged" then Jane when considering his debt in relation to cash on hand. But that's not everything, we also have to consider incomes and cash flows because that's going to tell us how well equipped the two are to service their debt, meaning pay the interest rates (and the minimums required on credit cards), to remain in good standing. If Jane is retired and pulling in 5% on her $2 million, she has an income (let's forget tax implications for the time being) of $100,000. Well, what if John is still working, with an income of $200,000? Now it gets a bit trickier. We need to think about what's more important: Is it the cash on hand or the continuing income? Of course, that depends on the sustainability of that 5% return for Jane and job security for John. The point is we need to consider several factors in relation to debt for individuals. Companies should be thought of in the same way. Here are three metrics we want to consider. Of course, there are many, many more. But let's start with some of the basics. 1. Net debt to EBITDA This is a very good leverage ratio to be aware of and one we consider before buying any stock. This ratio involves taking the net debt (which is essentially total debt minus cash and cash equivalents) and dividing it by a full year's earnings before interest, tax, depreciation, and amortization (EBITDA). The net debt-to-EBITDA ratio helps us determine appropriate debt levels in relation to the company's EBITDA generation. Now, some investors may take issue with EBITDA since it factors out the real cost of depreciation and amortization. However, it does make sense in this equation because, in a worst-case scenario, a company could look to pay off debts before replacing depreciated equipment, for example. In terms of a healthy ratio, the lower the better as it means that a company is more able to cover its debt obligations with the money it generates from operations. The number can change from industry to industry so comparing the company in question to the peer group and the company's own historic norms is a good idea. But in general, we want to see a ratio less than 3x. Anything above that and we need more information from management as to why it is so high and what is being done to lower it. A high ratio can be problematic not only because it increases the risk of default when business slows but also because it can make the cost of borrowing higher. Portfolio holding Procter & Gamble (PG), for example, has a net debt level of about $26 billion, and it's on track to generate about $21 billion in annual EBITDA, yielding a net debt to EBITDA ratio of about 1.24x — a low ratio indicating that P & G should have no problem paying off its debt and stands to keep its streak of annual dividend raises (67 consecutive years so far) alive and well. 2. Debt to equity The ratio compares the level of a company's debt on its sheet to the amount of equity. To calculate this ratio, we simply divide total liabilities by shareholder equity (which as a reminder is equal to assets minus liabilities). For example, if a company has assets worth $3 million and liabilities worth $1 million, shareholder equity equals $2 million ($3 million – $1 million) and debt to equity equals 0.5x ($1 million / $2 million). This is an important ratio that helps inform us as to whether management is implementing an appropriate capital structure. Are they using enough debt to maximize operating leverage? Or is it too much debt, making the servicing of that debt difficult and opening the company (and shareholders) up to the risk of default? Debt-to-equity should be considered against peers and take into where we are in the business cycle. But as a rule of thumb, consider a ratio in excess 2x something that should be closely scrutinized. A ratio of more than 4x is a red flag, which requires a clear understanding of how management plans to clean up the balance sheet or reconsider gaining exposure. Consider Club name Honeywell (HON), with a debt load of about $20 billion and shareholder equity of roughly $17 billion, amounting to a healthy ratio of about 1.18x — giving us little cause for concern in terms of financial health. 3. Debt service coverage ratio Since we just mentioned the importance of being able to service debt, let's consider a ratio that provides insight into that, the debt service coverage ratio. There are a few ways to think about this ratio — but at the highest level, the idea is to figure out a company's ability to service its debt. To do this, we use a metric such as operating income and compare it to the company's debt service requirement, meaning all principal and interest payments due in the next year. It's similar to the net debt-to-EBITDA ratio, but we're only considering current obligations (think short-term debt, the current portion of long-term debt, and any interest payments associated with the debt) rather than all financial obligations. Free cash flow is arguably the most conservative metric to use because at the end of the day, you can't service a debt with IOUs or accounting earnings if you don't have cash in the bank. As with most ratios, you will want to use full-year numbers for this analysis. The higher the number, the easier it will be to manage the debt. If for example, a company with free cash flow of $3 million and total debt on its balance sheet of $6 million, the debt service coverage ratio is 0.5x ($3 million / $6 million), meaning that one year of free cash flow can service half the company's debt. Take Club name Eli Lilly (LLY), for example, which has about $2.25 billion of debt payments to be made within the next 12 months. However, it's on track to generate upwards of $5 billion of free cash flow this year alone. With total debt standing at about $20 billion and no more than $650 million to $800 million due in any of the next four years, we see little reason to believe Lilly will have any problem servicing its debt. (See here for a full list of the stocks IN Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. 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This week's question: If I am evaluating a few companies in one industry. What is one good metric to compare their debt levels? — Gail