The Limitation of the Debt to Equity Ratio

Looking Past the Numbers to Understand the Debt to Equity Ratio

The Limitations of the Debt-to-Equity Ratio
The debt-to-equity ratio may not be a very useful financial metric in certain circumstances, such as when analyzing the financial statements of a business that has repurchased a lot of its stock as a sort of tax-efficient dividend. blackred / E+ / Getty Images

You've probably heard portfolio managers and famous investors say, "look beyond the accounting numbers and instead focus on economic reality." Over the years, countless readers have written and asked for practical examples of how that can be applied to their own portfolio. This article illustrates how one of the most popular financial metrics, the debt-to-equity ratio, can sometimes make an investment appear much riskier than it actually is.

Share Repurchases and Reduced Equity

As you learned in The Benefits of Stock Buy Back Programs, share repurchases can make you substantially wealthier by reducing the total number of shares outstanding, increasing your equity ownership as a percentage of the total business. Your respective portion of the profit and dividends grows even if the underlying enterprise does not. When combined with healthy, cash-generating operating results, share repurchases can result in huge long-term rises in earnings per share, as evidenced by companies such as Coca-Cola and The Washington Post.

Due to the peculiarities of Generally Accepted Accounting Principles (GAAP), however, wealth-creating buy back programs can actually cause a potential investment to appear riskier than it is in reality. The reason: When a company repurchases its shares, the result is a reduction in the stated value shareholders’ equity.

To understand why this occurs, we’ll have to delve into the accounting entries that are recorded each time stock is issued.

Imagine Seattle Enterprises, a fictional company that operates a chain of retail stores, wants to raise $100,000 for a new facility by issuing 5,000 shares of common stock. The shares have a par value of $5 each and will be sold for $20.

The accounting entry would appear as follows:

Cash Debit $100,000
Common Stock – Par Credit $25,000
Common Stock – In Excess of Par Credit $75,000

The corporation raises capital and the result is that the proceeds are allocated to two lines in the shareholders’ equity statement of the balance sheet; the first $25,000 consists of 5,000 shares issued multiplied by $5 par value per share; the remaining line results from multiplying the excess purchase price ($20 per share - $5 par value = $15 excess) by the number of shares issued ($15 x 5,000 shares = $75,000). The cash obviously ends up in the company coffers and must be debited to the appropriate account ($100,000).

Now, imagine a few years have past. Management wants to repurchase $50,000 worth of stock. The transaction is going look something like this:

Treasury Stock Debit $50,000
Cash Credit $50,000

Because the shareholders’ equity section normally has a credit balance, the Treasury Stock (a debit balance) serves to reduce the overall stated value. The result of this sad state of affairs is an increase in the debt-to-equity ratio. In fact, should the share repurchases grow large enough, it’s possible that a perfectly healthy, prosperous company could have a negative stated net worth and appear to be leveraged to the hilt!

“Couldn’t you argue that the cash has been spent and therefore the securities pose a higher risk because of the reduced asset base?” Yes, you could. If you own an excellent business that, by definition, generates tons of cash, however, this ordinarily need not be a concern. Your shares now receive a larger portion of the net income and dividends with no increase in the debt load.

Increased Payables as a Percentage of Inventory

Some management teams wisely attempt to reduce the level of assets tied up in working capital – things like cash on hand and inventory on store shelves. The reason is straightforward: each dollar freed is a dollar that can be used to pay down long-term debt, repurchase shares, or open new stores. At the same time, it is necessary to have sufficient products on the shelf to satisfy demand. Otherwise, potential customers won’t waste a trip!

A solution to this dilemma is a form of vendor financing known as pay-on-scan(“POS”). Here’s how it works: one of the executives at Seattle Enterprises (“SE”) will approach its vendors – the manufacturers and wholesalers of the products stocked on store shelves. Traditionally, SE selects the products they want to carry, orders them from the vendors, pays the bill, and sticks them on the shelf. Instead, the executive will propose that SE does not actually purchase the product until the customer has picked it up, walked to a cash register, and paid for it; the vendors, in other words, still own the products sitting on the shelves in SE stores. In exchange, SE might give the vendors volume rebates, special placement in stores, or other incentives.

The result is a drastic reduction of working capital risk and the ability to expand much, much more rapidly.

Why? When a retail company opens new stores, one of the biggest startup costs is the purchase of the initial inventory. Now that the inventory is being provided on a pay-on-scan system, all Seattle has to do is sign a lease, improve the property to match its other store designs, and hire new employees.

The lower upfront costs will allow it to open two or three stores for every one store it could afford prior to the POD system implementation!

The only apparent drawback of this arrangement is a dramatic increase in accounts payable account, which shows up on the balance sheet as a short-term liability. Despite the fact that the business doesn’t really have any additional risk – the product, remember, can be returned to the vendor if it is not sold – some investors and analysts treat this debt as an obligation that could threaten liquidity! This is clearly a case of accounting not representing economic reality. The shareholders are infinitely better off despite the apparent rise in the debt to equity ratio.

Case Study

A perfect example of this phenomenon is AutoZone. (Let me say up front that at the time this article was published, I owned shares of the company. Please remember, however, that all investment decision should be driven by your estimate of intrinsic value. Over the past several years, the stock has traded in a range from around $25 to over $100; it may be a wonderful investment at one price, a terrible investment at another. Therefore, it is inappropriate for you to consider purchasing a stock, bond, mutual fund, or other asset simply because you know someone else has a position in it.)

The number-one retailer of automotive parts and accessories has seen net income increase from $245 million in 1999 to $566 million in 2004.

At the same time, earnings per share have risen from $1.63 to $6.40. Common equity, on the other hand, has fallen from $1.3 billion to $171 million while the debt to equity ratio has skyrocketed from around 40% to over 90%. There are two primary reasons:

  • AZO has repurchased nearly half of its outstanding shares over the past five to ten years, decimating common equity while providing a nice boost to EPS.
  • The management team has successfully migrated over 90% of vendors to a pay-on-demand arrangement, increasing the accounts payable balance substantially while reducing the investment in working capital.

These moves were tremendously beneficial for shareholders, yet the apparent risk appeared to increase due to the limitations of accounting rules. The moral of the story? Always look deeper; focus on economic reality, not merely reported earnings and ratios.