One Underused Balance Sheet Metric

by Daniel Sparks

writer at

the Motley Fool

What is a Balance Sheet Metric


Balance Sheet Metric

Balancing Act – Balance Sheet Metric | Richardstep.com

As Mary Buffett & David Clark, authors of Buffettology have accurately pointed out,

“Warren has found that a company with [a] durable competitive advantage spins off a lot of cash and has little or no need for debt.”

In other words, a good indicator of an economic moat is a balance sheet relatively free of long-term debt.

But before investors analyze a balance sheet, it’s important for them to differentiate between a cigar-butt value investment in which investors are aiming to purchase liquid-able assets at a discount, or an investment in a business for its growth or dividend.

An investment in Apple, for example, would not be based solely on its liquid-able assets.

For instance, at 3.4 times book value, Apple would not be able to return $450 per share to investors if the company halted operations and sold off its assets.

Gravity (GRVY), on the other hand, would likely serve investors well in the case of a liquidation; at today’s price, the stock trades at just .4 times book value.

Though seasoned investors grasp this concept with ease, the beginner investor might have trouble understanding that each stock’s balance sheet deserves a somewhat unique and line-by-line analysis.

Balance Sheet Metric – There is a Problem with the Debt to Equity Ratio

As far as analyzing a company’s debt situation, in particular, investors should be careful not to jump right to the debt-to-equity ratio. There is a huge problem with the debt-to-equity ratio when it comes to assessing companies as ongoing concerns: It takes free cash flow to meet debt obligations, not equity.

So what is an alternative to the frequently used debt-to-equity ratio? The long-term debt burden ratio.

An Alternative to the Debt-to-Equity Ratio

The commonly used debt-to-equity ratio is, unfortunately, not always a useful measure of financial health, especially when examining wide-moat stocks.

The debt-to-equity ratio measures debt relative to assets. But since the wide-moat stock probably won’t be liquidating assets any time soon (if it is liquidating, it’s probably not a wide-moat stock), it is better to focus on a firm’s ability to service its debt.

As Mary Buffett and David Clark emphasize, “the ability of a company to use its cash flow to service and pay off the loan is far more important than the assets backing it up” (click to tweet this quote).

So, to assess financial health, I divide long-term debt by TTM free cash flow (FCF) (or owner earnings) to find out how many years it would take the company to pay off its long-term debt with its current cash flows.

This ratio is referred to as the long-term debt burden.

A rule of thumb is that companies with durable competitive advantages can typically pay off their long-term debt with three years of TTM FCF or less. Hence, wide-moat companies should have a long-term debt burden ratio of three or less.

Since smaller companies have very volatile FCF and owner earnings, it’s important to take a look at this trend closely and use an initial number that makes sense. After evaluating the company’s competitive landscape, some sort of average is often sufficient, unless the landscape has changed dramatically in the recent past.

Take your time on this part. As the saying goes: garbage in, garbage out.

An Example of the Long-Term Debt Ratio In Use

Here is an example of five companies that have either a narrow or wide moat designation by Morningstar.

True to their moats, all of the companies have a long-term debt burden of less than three years.

The ratio typically uses earnings, but I feel that free cash flow or owner earnings paints a clearer picture. Free cash flow is ultimately what is used for long-term debt repayment after short-term commitments have been met.

When to Deviate

Yes, Buffett sometimes breaks this rule of thumb of “three or less.” Railroads, for example, typically carry very high levels of long-term debt. Berkshire’s largest acquisition to date, of course, was Burlington Northern Santa Fe Railroad.

A deviance from this rule of thumb should be based on at least one of two reasons:

  1. The stock is significantly undervalued with more than enough margin of safety.
  2. The company has obvious and significant barriers to entry (e.g. railroads).

What ratios do you use to analyze the wide-moat companies balance sheets? Tell us about your balance sheet metric in the comments below.

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3 responses to “One Underused Balance Sheet Metric”

  1. Jason Graves says:


    Great article. I’ve read Buffetology and have been using Debt/FCF for years. Glad to see someone writing about it.

    The average ratio can fluctuate by industry but I’ve found that a ratio of 5 or less is pretty safe.

    I think of a home mortgage… if you could pay down the mortgage on a house in 5 years or less, that shows good financial stability. 6-10 years = less stable. 10+ years and I get nervous.

    Thanks for the article.


  2. Daniel says:

    Jason. I really like the analogy of the home mortgage. If people were investable, 5 years or less would be solid news. Glad you’ve heard of the metric before. I think it is definitely underused, hence the article. Thanks for your thoughtful comment

  3. somrh says:

    Yeah, I think debt/equity is probably only useful for financial firms with liquid assets that are marked to market. I agree that debt to cash flow (or something similar) is a far better metric.

    The other thing that I would look at which isn’t so much a metric (although one can invent one) but it relates to the maturity of the debt.

    To use your Disney example, suppose that Disney’s debt to cash flow is about 3 years but they have no cash on hand and their debt matures in 2 years. That would mean that Disney would have to refinance when the debt matures.

    Hyman Minsky has a borrower schema that fits this well (describe it here:http://caps.fool.com/Blogs/minskys-borrower-schema/740990). In my version of the Disney example, it would classify as a “speculative borrower”.

    Hedge borrowers would be the safest ones as they have sufficient cash flows to pay both interest and principal.

    To construct a metric out of it, one might take your long-term debt ratio and compare that to, say, a “weighted average maturity” of that debt. If the debt ratio is less than the weighted average maturity you have a hedge borrower.

    This would allow you to look at companies with higher debt ratios. If a company has a debt ratio of 5 years and weighted average maturity of 10 years then it should be safe (all else being equal).

    As a side note, the other place one might argue Buffett deviates from the “under 3” debt ratio is in regard to banks. Banks are inherently speculative (per Minsky’s schema) as their debt is being continuously rolled over. Of course most banks have a “lender of last resort” as a backstop so refinancing risk is reduced.

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