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Part 1 of the Stock Selection Guide lets investors see how successful management has been in the Past at growing revenues and earnings per share (EPS). Part 2 of the Guide is designed to help investors make judgements about a company's future growth in revenues and EPS. This is done by assessing management's operational efficiency and effectiveness.
The last issue discussed the Operating Profit Margin (OPM) and how it can be used to assess the efficiency with which a company's management makes and sells its products. If historical revenues and earnings have been growing at a steady pace but the trend in OPM is down, continued strong growth might be problematic.
The Debt Ratio is another measure investors can use to help them make judgments about a company's potential for future growth in revenues and EPS.
Generally, investors value the sensible use of debt. As long as borrowed money can be invested by management to earn a rate greater than its cost, the excess return becomes available to common shareowners. However, reliance on debt creates a binding obligation to "service" the debt by paying interest and repaying principal on schedule. If a company fails to service its debt, shareowners will be forced to surrender control to creditors-an investor's worst nightmare.
ASSESSING DEBT
The Debt Ratio lets investor see what percentage of a company's assets are funded by borrowed money. It is calculated by dividing a company's total debt (both current and long term) by total assets:
(Equation omitted)
Normal Debt Ratios vary from industry to industry. Predictability of a company's revenues and the ability to control the price of the company's product in the marketplace are key determinants of a sensible amount of debt. Generally, investors tolerate much higher Debt Ratios from companies in industries that are highly regulated (e.g. utilities) than from companies in emerging, high-risk or cyclical industries.
Usually, investors prefer to see moderate Debt Ratios that fluctuate little from year to year. This would indicate that a company is aggressive enough to use some borrowed money to finance its operations and/or new ventures, but prudent enough not to rely excessively on debt.
HOW DEBT CAN AFFECT FUTURE GROWTH
Although a company's management might...