Applying Value Analysis to Liabilities and Solvency

Up to this point, we’ve now examined how to evaluate aspects of the revenues, expenses, and assets of a company using value analysis. Having looked at the asset evaluations we’ve already completed, it is equally important to evaluate the liabilities that a company incurs.

Since liabilities reduce an investor’s claim to assets in the event of liquidation (and therefore reduce our valuation of them), it is important for us to consider them as having considerable consequence to our portfolio. As a value investor, the best way to do this is by examining them as functions of Solvency. Solvency refers to the ability of a company to pay off its obligations, as well as its ability to scale operations through leverage. While leverage is not necessarily a good thing to a value investor, the capacity to increase leverage is considered positive.

The information below illustrates a few fundamental value investing ratios that evaluate company liabilities as a function of solvency.

  • Total Debt Ratio: Liabilities / Total Assets

    The total debt ratio is an indicator of the proportion of debt that a company holds for each dollar of assets owned. It represents the leverage of a company, as well as its ability to liquidate its assets to pay off debt. In the event of liquidation, a lower Total Debt Ratio would represent a higher ability to pay back investors for their losses. In general, a lower ratio represents a greater margin of safety against sudden swings in the industry.

  • Debt Equity Ratio: Total Debt / Equity

    The Debt to Equity ratio is a staple metric in the investments industry. Similarly to the Total Debt Ratio, it illustrates company’s leverage, as a function of its equity investment. If a company has more debt than it does equity, it is highly leveraged. While this will make the company more sensitive to swings in the market, it can also be an extremely effective source of financing for a company that is in a favourable cash flow position. Lastly, the Debt-Equity Ratio can be an indicator of whether or not a company may be inclined to later dilute out other investors by issuing more shares. Even though this would decrease the company’s exposure to its debt, this is not the best route to pursue.

  • Cash Coverage Ratio: EBIT + Depreciation / Interest

    The Cash Coverage Ratio indicates a company’s ability to handle leverage, to manage its current debt load, and to continue operations without fear of bank intervention. Interest payments are what determines if a business will stay in business. As soon as the bank becomes afraid for the safety of their loan, they can pull the plug on operations almost overnight.

    However, if a company has a high Cash Coverage Ratio, it is better able to continue making these payments, as well as any other commitments that may arise as a function of debt. This means that the Cash Coverage Ratio represents the ability of your company to maintain continuity until the market comes to appreciate its full value.

    One thing to beware of with this metric is the impact of depreciation. Since depreciation does not necessarily represent a cash transaction, it can be misleading, and artificially increase this metric. Beware of companies with extremely high depreciation values, and no balancing earnings.