Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you specific investment advice, including the best use of financial ratios in your stock research. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Assessing a company’s debt is important, but you can be misled by the numbers.”

The issue of debt appears regularly in the media these days—whether it’s the debt of governments or the indebtedness of the population at large. Deciding whether a company has too much debt is certainly an important factor for investors.

Many experienced investors begin their stock research by looking at ratios such as a company’s debt-to-equity ratio. This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt with its shareholders’ equity.

A high ratio of debt to equity increases the risk that the company (that is, the shareholders’ equity in the company) won’t survive a business slump. However, this ratio can mislead, because it compares a hard number with a soft one.

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Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course).

But figures on a balance sheet may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance-sheet figures by trimming them back or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

Stock research: The debt-to-market-cap ratio can say more about a company’s long-term prospects

Instead of overemphasizing the debt-to-equity ratio, we recommend that you expand your stock research to look at the ratio between a company’s debt and its market capitalization or “market cap” (the value of all shares the company has outstanding).

Like shareholders’ equity, market cap may differ widely from the net value of a company’s assets. However, a moderate debt-to-market-cap ratio will tend to provide a conservative starting point for analyzing a company’s chances of survival.

A great example that we like to cite is Coca-Cola Co. (symbol KO on New York). The company has long-term debt of $13.7 billion, which represents a moderately high 41% of its $33.4-billion shareholders’ equity. But that debt is just 8.5% of its market cap.

The difference reflects the fact that the company’s balance sheet doesn’t show the true value of its most valuable asset — its so-called intellectual property. In Coke’s case, one key asset is the secret formula for Coca-Cola, which is reputedly carried on the company’s books at one dollar (and was recently moved with great fanfare to a new vault in Atlanta). More important, the Coke brand name carries no value on the company’s balance sheet. However, these are reflected in its huge market cap of $160.6 billion. So, put into perspective, the company’s debt is very low.

In contrast, penny mines often have low debt-to-equity ratios. But their shareholders’ equity reflects a lot of investments in mineral properties that will almost certainly never result in any significant revenue. And one good reason that their debt is low is simply that no one wants to lend them money.

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