Intro to Credit Risk Analysis: Debt-to-Equity Ratio

If recent financial market events have taught us anything, it's that a) leverage can work both ways, and b) when leverage works against an individual/corporation/investment entity, the results can be fairly disastrous. Although the pair of statements above are essentially commonly held knowledge, the behavior exhibited by market participants throughout the past 20 years was nothing if not a blatant disregard for this reality. Moving forward, it will be more prudent than ever for investors to perform a sober assessment of a corporation's use of leverage.

At the heart of credit risk analysis is a corporation's solvency, or in other words, it's ability to function as a going concern, capable of avoiding financial distress. The cornerstone of evaluating solvency is the Debt-to-Equity Ratio, which as the name implies, looks at a firms absolute debt level in terms of a multiple of total stockholders' equity. Both parts of the equation can be found on the balance sheet, and are plugged in as follows:

Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity

Verizon's (VZ) Debt-to-Equity Ratio is calculated as follows:
Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity
= $160,646M / $41,706M
= 3.85

In other words, for every dollar of Shareholders' Equity, Verizon holds $3.85 worth of debt. This ratio will obviously fluctuate greatly based upon the industry, and the composition of the firm's funding sources, i.e. relative breakdown of debt v equity funding. The chart below compares Verizon with seven other large firms from a debt-to-equity ratio standpoint:
Clearly, the debt-to-equity ratio needs to be examined from within the context of the individual firm and industry as a whole. For instance, there are two reasons why I wouldn't be alarmed at Verizon's high ratio of debt funding. First, it's subscriber based business provides relatively stable and predictable cash flows; a distinction that translates into ample access to the bond market. Secondly, a major portion of Verizon's borrowing activity over the past couple of years has been geared towards investment in it;s FiOs network. I haven't assessed that product from a consumer standpoint, but feel certain that Verizon will be able to leverage it's market leadership position into a substantial FiOs subscriber base.

Step 2 in the credit risk analysis process is determining the firms ability to cover interest payments from internally generated cash. That ratio will be addressed in a future article.

*no positions
Sphere: Related Content

Verizon's Net Falls; Revenue Defies Trend

Verizon Communications (VZ) reported a 21% quarterly decline in net income, although the wireless behemoth's sales increased by 11.3% compared to the same quarter a year ago. The Company's results are essentially inverse to what we have seen coming out of of corporate America for the current quarter, as Verizon's net was adversely affected by extraordinary/one time items, despite logging sustainable revenue growth. This contrasts with the new, popular way of doing business, which involves draconian costs cuts and the fire-sale of critical components of the business (Citigroup) in order to hand Wall Street the EPS numbers they are pining for. Needless to say, revenue growth is not customary in the current economic environment.

The fact that Verizon was able to add 1.1million new subscribers during the quarter, in addition to increasing the top-line, would seem to indicate that cell-phones have emerged as a highly recession resistant luxury item. The fact that anybody would argue with us concerning cell phones status as a "luxury item" only proves our point further. Communicaion in and of itself is obviously not a luxury, however, when a 15 year old girl has the latest Blackberry storm International Edition, something has gone clearly gone awry with the country's ability to prioritize it's spending.

From an investment standpoint, Verizon fits nicely within our parameters for an attractive company: It is generating massive amounts of cash - each second - and it's product has drifted into the realm of non-discretionary purchases. As always though, these are just our parameters, and aren't necessarily suitable for everyone.

Disclosure: no position in VZ Sphere: Related Content