Screening - Debt Levels
Given a choice, investing in a non-financial company that uses little debt is much better than investing in one that uses debt extensively. But it’s hard to create a simple rule for the amount of debt a company should use.
In Brandes’ book, “Value Investing Today” he uses a general rule of not investing if the level of debt is greater than 100% of tangible equity. Like any other rule with regard to the correct level of debt, this rule is a huge oversimplification.
First, financial companies use a tremendous amount of debt in their operations and should be evaluated against a much different target. The industry in which the company operates matters a great deal when evaluating the debt level of a company.
Second, tangible equity is an accounting idea only. It does not reflect the actual value of the company. The value of debt should be compared to the value of equity which is better reflected by market values than accounting values.
Third, debt should be adjusted for other debt items not reported as debt on the balance sheet. Capital leases and net pension liabilities, for example, should be added to the debt on the balance sheet to get a more realistic estimate of a companies debt level.
While the level of the debt used by a company in it’s operations should be closely evaluated because debt adds risk and can disguise low returns from operations, the evaluation of a companies debt level should involve more than a quick glance at their balance sheet.
