Debt to Equity (DE) Ratio

The debt to equity ratio is widely considered the most important indicators of financial health. It measures the financial health by assessing the split between the two financing methods discussed above, debt and equity. It represents the portion of the company that belongs to its lenders versus its shareholders.

The word "debt" is used here as shorthand to refer to all liabilities rather than just borrowings. The Cambridge Dictionary defines debt as something that is owed to someone else, which applies to liabilities as well. However in this context, the person owed could be someone like a landlord or a lessor, not necessarily a lender. As far as I know, whether the word is being used to mean liabilities or borrowings is context-dependent, and there is no easy way of knowing when each one applies.

Companies must always pay their obligations no matter how much money they earn, so the greater the debt to equity ratio the more the company may struggle in an economic downturn. In extreme cases, if a company cannot pay its obligations it can go bankrupt.

The lower the debt to equity ratio the better. However, some industries, such as mining or manufacturing, involve large fixed assets which are appropriately borrowed rather than bought outright, in which case the ratio will naturally be higher. The consensus is that a DE ratio below 2.0 is safe, but I believe you should look for a ratio below 1.0.

Cash to Total Debt Ratio

The cash to total debt ratio is one of Warren Buffett's favourite metrics for measuring a company's financial health. It measures the company's debt level by comparing it to the current cash balance.

If the ratio is greater than 1.0, the company could pay off all of its debt immediately if it wanted to. This is extremely healthy because it means debt is completely manageable. Even if the business didn't earn another dollar it wouldn't go bankrupt. This also shows a high level of flexibility, as the company can choose to distribute cash to shareholders, reinvest in the business, or simply hold onto it for safety.

However, high cash to total debt ratios should be within reason. We know that some level of debt is okay because it increases shareholder returns through leverage. Once cash is high enough to afford sufficient protection in case something bad happens, it is better to see excess cash being used to grow the business or returned to shareholders through dividends or share buybacks.

In saying this, company managers are generally aware of these concerns and know how best to deploy their cash. That's why I believe having high amounts of cash is pretty much always a good sign. You should look for a cash to total debt ratio above 0.5.

Current Ratio

While the debt to equity ratio is a good measure of overall financial health, companies can still run into trouble if a large portion of liabilities are current liabilities, meaning they are due within the next 12-months. A more short-term measure of financial health is the current ratio. The current ratio measures the company's ability to meet its short-term obligations.

The lower the current ratio, the greater the portion of the company's income will have to spent on meeting its current obligations. This, is in turn, means the company faces greater financial risk if market conditions are unfavourable and the company doesn't earn enough.

However, if the current ratio is extremely high, for example 3.0 or above, it may indicate that the company is not utilising its assets efficiently.

You should generally look for a current ratio between 1.0 and 3.0.

Cash Flow Coverage Ratio

The cash flow coverage ratio is an extremely effective measure of financial health. It measures the company's debt level by comparing it to how much cash is generated by core operations. This is an effective measure because, unlike accrual-based measures like current assets, cash is what the company actually uses to pay back debt.

The higher the cash flow coverage ratio the better. A ratio above 1.0 indicates the company could pay off all of its debt in one period from just its core operations. In fact, taking the reciprocal provides a figure that represents how many periods it would take to pay off all debt. For example, a ratio of 0.5 indicates it would take a minimum of two periods (1 / 0.5 = 2) to pay off all debt.

​Other Things to Consider

One of the other things I like to look at on the balance sheet is how debt evolves over time. For example, if debt is stable or decreasing over time it is evident that it is within a level that is manageable by the company. On the other, if debt is consistently increasing over time it is an indicator that the business is not making enough money to cover interest payments. It's also possible that the business is simply relying on debt financing to expand its operations, in which case you would like to see revenue expanding at the same or faster pace then debt.