A high level of debt often scares investors away from otherwise solid companies. A high debt-to-equity ratio often causes suspicion as well. An exception is usually made for banks, because they need to borrow money to lend money. What happens, however, when a non-bank has an extremely high debt-to-equity ratio? Many investors see it as a troubling trend, but I’m here to tell you why debt levels can be deceptive.
Does IBM have a debt problem?
A big reason for the abnormally high ratio originates from International Business Machines Corp. (NYSE:IBM)’s Global Financing (IGF) division. IGF is used for things like financing credit-qualified clients who want a more cost-effective way to acquire services from “Big Blue”. Debt from financing can almost be seen as “good” debt (if there ever were such a thing), because it makes the company money. IGF was responsible for almost 9% of the company’s pre-tax earnings last year.
Looking at International Business Machines Corp. (NYSE:IBM)’s balance sheet from its most recent quarter, its huge $34.1 billion debt load might immediately scare you away at first glance– especially considering there’s only around $10 billion in cash on the books. After factoring in what this debt is attributed to, however, your concerns may be eased.
Debt from financing activities actually accounted for $24.9 billion of the overall debt load, which means International Business Machines Corp. (NYSE:IBM)’s “core” non-financing debt was only at about $9 billion. This means the company actually has more cash than core debt. That is more than sustainable, and it shines a light on International Business Machines Corp. (NYSE:IBM)’s healthy, liquid balance sheet. When factoring in the $2.7 billion in free cash flow the company generated during its recent quarter, it becomes clear that International Business Machines Corp. (NYSE:IBM) is very strong overall financially.
Will Ford Motor Company (NYSE:F) be doomed by its debt?
On Ford Motor Company (NYSE:F)‘s balance sheet, its roughly $15 billion in automotive debt looks quite manageable in comparison to its current cash level of around $14 billion. A current ratio of almost 2 also indicates high liquidity. About $91 billion of its $107 billion in total debt is due to Ford Credit, one of the company’s stronger assets. This can be chalked up as good debt, because its credit risk is generally low.
This debt is accompanied by an asset (a car that can be recovered if the debt isn’t repaid), or is lent to Ford Motor Company (NYSE:F) automotive, which means that the company is financing itself at wholesale rates. Ford Motor Company (NYSE:F)’s debt looks troubling at only a quick glance, without proper due diligence.
Like IBM, Ford Motor Company (NYSE:F)’s financing activities generate profits and provide valuable services to customers. Digging deeper into the source of its debt reveals that the majority of it originated from Ford Credit, one of the company’s stronger assets. For all reasons mentioned, investors shouldn’t avoid Ford Motor Company (NYSE:F) because of superficial first impressions.
When financial services go wrong…
Companies taking advantage of financing sometimes make mistakes that hurt shareholders. A perfect example can be illustrated by General Electric Company (NYSE:GE)‘s past. During the financial crisis, concerns about GE Capital, the company’s financial services arm, caused an otherwise solid industrial conglomerate to lose its triple-A credit rating. It was probably even the root cause behind the company’s dividend cut. Could this scenario also happen to IBM and Ford?
IBM and Ford are much more conservative now with financing activities than General Electric Company (NYSE:GE) was before the crisis. GE Capital was, and may still be, a different story. At the time, it was invested in real-estate businesses, overseas banking, insurance operations, and all kinds of other financial endeavors. This led to much more complexity than, say, Ford leasing cars through Ford Credit. GE Capital is also a bank, not just a financing unit of the company.
It is always wise to pay attention to a company’s financing activities to ensure that they are not being utilized for risky behavior. Luckily, General Electric has recognized the need to “trim the fat” on GE Capital by selling off, or planning to sell-off, non-core parts of it. GE Capital itself is so big that it would be the fifth-largest bank in the U.S. if it were a separate institution. It is also still incredibly profitable in good times– contributing 47% of its parent company’s operating earnings in the first quarter.
The bottom line
Pre-financial crisis General Electric is a classic example of when risky financial aspects of an otherwise solid company can crater shares. Ford and IBM, however, are using financing responsibly. Both companies look much stronger when their true debt situation is fully grasped.
Regular and financing debt are usually separated on the balance sheet and in earnings reports. Subtracting financing from total debt will give you the amount of regular debt. If you’re looking into a stock that carries an abnormal amount of debt, check first to see whether that debt stems from profitable financing activities before you cast it off as a troubled company.
High debt levels can be deceptive. Now you know that they aren’t always detrimental, either.
The article Don’t Be Deceived by Misunderstood Debt Levels originally appeared on Fool.com and is written by Joseph Harry.
Joseph Harry owns shares of International Business Machines (NYSE:IBM)., General Electric Company, and Ford. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford, General Electric Company, and International Business Machines. Joseph is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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