Limitations of the Debt to Equity Ratio

The Limitations of the Debt to Equity Ratio

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, a company can make you richer 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.

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 buys back its shares, the result is a reduction in the stated value of  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 that 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 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 cashobviously ends up in the company coffers and must be debited to the appropriate account ($100,000).

Now, imagine a few years have passed. 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!

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”). Under this system, a company does not actually purchase a product until the customer has 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, none of that is necessary. 

The only apparent drawback of this is that the products show up 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! It is clearly a case of accounting not representing economic reality. The shareholders are better off despite the apparent rise in the debt to equity ratio.