With the many accounting debacles recently, there is more interest from traders in understanding a comapny's financials.  And I do like to write articles that help you understand the important things to look for when doing a fundamental analysis of a company.  Today I will look at the importance of corporate debt and how to analyze a company’s liquidity.

Economic theory says that the mix of debt and equity in a company’s capital structure is irrelevant, and that the value of a firm should be independent of its debt ratio.  In the real world, companies and investors have to worry about things like taxes and the risk of default.  A company's capital structure is relevant to its long-term survival.  Long-term creditors will usually put restrictions on the company, perhaps preventing it from taking on additional debt or paying higher dividends. 

Of course most companies have at least some debt, and the biggest reason to take on debt is to leverage the equity (much like buying stock on margin).  Return on equity is very important to investors.  But the greater the proportion of debt to equity on the balance sheet, the higher the business risk.

Since a lot of corporate debt tends to be short-term, there can be a real risk to the company if investors lose confidence in it.  It is not unlike a run on a bank, where liabilities (loans) have a longer duration than their assets (deposits).  If everyone suddenly wants their money now, the bank will not be able to meet the demand and be forced to close.  That is why it is important to look at a company’s debt and liquidity. 

Liquidity in the option markets refers to the volume of contracts changing hands in a day. There is lots of liquidity in the options of companies such as IBM and Microsoft, since there are many buyers and sellers.  However, liquidity means something very different at the company level.  Here we are referring to whether or not the company has, or can generate, enough cash to keep operating if they had to pay off short-term debt quickly. 

Banks use liquidity analysis to assess the risk of a company not being able to repay them in the short term.  Agencies rate a company’s debt according to the perceived threat of default.  Still, crises periodically seem to emerge from almost nowhere to cause the sudden collapse of companies that seemed solid only weeks before.  Once investors lose confidence, as companies such as Enron, Qwest and Tyco learned recently, liquidity can mean the difference between survival and death.  For this reason, investors should always take a little time to check debt and liquidity ratios before taking a position.

Most investors are familiar with the corporate bond market.  When a ratings agency such as Moody’s or Standard and Poor’s downgrades a company’s debt, this certainly causes the company’s bond holders some distress, as the value of the bonds will drop.  Still, since corporate bonds are primarily long-term debt, this is not usually the source of liquidity problems (unless a large amount just happens to be nearing expiration).  No, it is usually a company’s short-term debt that gets them in trouble.

Corporations today no longer rely on banks for the bulk of their working capital and short-term cash needs.  Most rely on issuing commercial paper, which consists of short-term, unsecured promissory notes issued by the company. Maturities can range up to 270 days, but average about 30 days and are often simply rolled over day-by-day.  Most companies use commercial paper to raise cash needed for current transactions, and simply keep rolling it over each time the notes come due. 

When a company runs into financial problems, their debt rating is usually quickly downgraded.  Investors demand a higher premium to lend to the company, and, if they lose confidence altogether, simply refuse to lend at any price.  If the company does not have liquid assets available, even a temporary cash flow problem can quickly become life threatening.

Of course, the banks still back them up in the short term.  Before investors will buy commercial paper, they usually require a commercial paper back-up facility with a bank.  This gives them a bit more security that they will be paid.  However, this facility is not meant to be used, and drawing on it is an admission the company is having severe liquidity problems.  This is what happened to Qwest a couple weeks ago.

When Qwest had trouble borrowing in the commercial paper markets, they had to draw down their $4 billion credit line with banks.  It was a stop-gap measure that put off a financial reckoning for a few months, but credit agencies responded by cutting the rating on its bonds to near junk status.  $4 billion is a lot of money to come up with in short time, compared to their financial status: market capitalization, currently $16.4 billion, revenue in 2001 of about $20 billion, and a loss (no earning) of $4 billion for last year.

So one of the first measures an investor should look at is the ratio of a company’s debt to its total capital.  Total capital is debt plus equity.  This ratio should be compared with industry norms, not simply against all other businesses.  Next, a company's ability to meet its debt payments is measured by “times interest earned”.  Times interest earned is a company’s earnings divided by their total interest cost.  For earnings, you could use EBIT (earnings before interest and taxes), or the more aggressive EBITDA (which adds back the non-cash costs of depreciation and amortization.  Of course, none of these measures really mean much if the company can't sustain a profit over a longer term.

If you are not looking at looking at a company’s financials, other investors certainly are.  Below is a table I put together with some of these key numbers, comparing Qwest to the other “baby bells”, SBC Communications (Symbol: SBC), Verizon (Symbol: VZ), and Bell South (Symbol: BLS) last year, with numbers in billions of dollars:

You can see that Qwest had a substantially higher amount of debt relative to their equity.  Their times interest earned number looks particularly bad in comparison.  Investors clearly recognized over the past year that Qwest was a substantially more risky investment, with a worse financial outlook compared to its peers.  Below is a chart comparing the financial performance of these four companies for the period March 2001- March 2002:

Investors should also look at a company's current ratio and the quick ratio.  The current ratio is a measurement of cash resources relative to the short-term level of obligations and is an adequate measure of financial strength in the short term.  It's measured by dividing all current assets by all current liabilities. 

Current assets include cash and equivalents, marketable securities, accounts receivables, inventory, and prepaid expenses.  Current liabilities include all debt due within a year.  This ratio gives you a sense of a company's ability to meet all short-term liabilities with liquid assets, should it need to.  A ratio of 1 implies adequate current assets to cover current liabilities, and the higher above 1, the better (Qwest had a current ratio of 0.6).

The quick ratio is a bit more conservative measure of liquidity.  It is the current ratio after subtracting inventory from current assets.  Again, a healthy company should have a quick ratio of at least 1.0 (Qwest had a quick ratio of 0.5).  The most conservative ratio would be the cash ratio, which is the sum of cash and marketable securities divided by current liabilities.  I rarely use this one myself, because it requires more work to dig out and calculate.  The other ratios are easily found on any decent financial website.

As you can see, the ratios for Qwest were well under 1.  Does this mean you should look for this in other companies and immediately enter short positions (like buying puts) on them?  Not Necessarily.  All the “Baby Bells” (Bell South, SBC Communications, and Verizon) have similar current and quick ratios between 0.4 and 0.7.  The key here is investor confidence.  These companies could go on like this indefinitely, as long as investors retain their confidence in them.

What does this mean for long-term investors?  First, Quest has exhibited much more price volatiltiy than its peers.  More importantly, You would have made more money over the past five years choosing one of the other baby bells.  The chart below compares the growth of $10,000 during that time period between these four companies:

Quest got caught up in the tech and telecom bubble more than any of its peers,  So if you got out at the height of the bubble, you obviously would have made more.  But if, like most investors, you continued to hold on through the collapse of that buble, you would have lost about two-thirds of your original investment.

The other big difference betwen Quest and the others is that Quest pays no dividend, while the others pay fairly substantial ones.  Below is a chart showing the actual total return over the past three years for these four companies:

You clearly would have done much worse with Quest.  At the top I you will notice one more I added, Alltel (Symbol: AT).  I put this one in, because back in the beginning of 2000 as the tech bubble was bursting (although few had quite realized it yet) my father asked me what I thought about buying Quest as a good long-term telephone company stock for his retirement account.  Based on my fundamental analysis, I said it was probably not a good idea, and suggested Alltel instead.  Luckily he took my advice, and still holds it in his Roth IRA to this day.

Just as no option strategy works in every market and situation, there is no one financial number or ratio that can give you all the information you need.  That is why it will take several articles just to touch on all the important parts in a fundamental analysis of a company.  Like anything else, you will find it gets easier and faster to do this with practice (I promise).  Hopefully this article has convinced you the importance of at least looking a company’s debt and liquidity before entering any positions.