We all know that the more indebted a company is, the greater the risk of bankruptcy. But what is really the best way to measure this indebtedness? In this post we will compare two of the best known leverage ratios: Debt/Equity (Debt-to-Equity) and Net Debt/EBITDA (Net Debt-to-EBITDA).

Leverage Ratios

Leverage ratios are financial metrics used to measure the level of debt a company has incurred and its ability to meet its financial obligations. There are many leverage ratios, but in this post we will focus on the following two:

Debt/Equity

This is the most widely known and used leverage ratio. Its formula is as follows:

\(\begin{equation} \textrm{Debt-to-Equity Ratio}\ =\dfrac{\textrm{Total Debt}}{\textrm{Total Shareholder’s Equity}}\end{equation}\)

The issue with this ratio is that a company’s Equity can fluctuate greatly from one year to the other, depending on the company’s capital allocation policy. In fact, Shareholder’s Equity can even be negative. This does not necessarily mean that the company’s financial situation has worsened.

The problem lies in the Retained Earnings statement, which is one of the components of the Total Shareholder’s Equity. On the one hand, this statement accumulates the profits/losses of the business, so its growth is a sign that the company is generating profits, which is a good thing. But on the other hand, the same statement also subtracts the money returned to shareholders, either in the form of dividends or buybacks. And the latter is what can eat away at the Retained Earnings, until Equity becomes negative.

A negative Equity is not bad per se. In fact, there are a large number of high quality companies with negative Equity, due to its shareholder retribution policy. Some examples are: Home Depot ($HD), McDonald’s ($MCD), Starbucks ($SBUX), Lowe’s ($LOW).

In the image above we can see how since 2010 $LOW’s Reatined Earnings have been decreasing year after year due to its aggressive share repurchase plan. So much so, that its Equity has become negative in 2022.

Net Debt/EBITDA

It is a leverage ratio focused on measuring the company’s ability to pay off its liabilities. It is calculated as follows:

\(\begin{equation} \textrm{Net Debt-to-EBITDA Ratio} =\dfrac{\textrm{Total Debt } – \textrm{ Cash and Equivalents}}{\textrm{EBITDA}}\end{equation}\)

This ratio is not free of problems either. Firstly, it is a ratio that does not work for early stage companies that are not yet making money and have a negative EBITDA. And secondly, although a company’s EBITDA is usually fairly stable from one year to another, it is true that in the case of more cyclical companies some years we may encounter an anomalous EBITDA that distorts the ratio. In this case it would be recommendable to use a normalized EBITDA.

However, unlike Debt-to-Equity, this ratio can be negative and still make sense, as long as the EBITDA is positive. In this case, what it means is that the company has more cash than debt. So the business is not really leveraged.

Which ratio is better?

As we have seen, each ratio has its advantages and disadvantages. So the question arises as to which of the two is better? Which one can better alert us to the dangers of over-indebted companies?

Let’s take a look!

To do so, we are going to run some quintiles simulations for the S&P 500 universe, from 2005 to the present. We will construct the quintiles as follows:

1. For each day take the components that were in the S&P 500 on that day.
2. Calculate their ratio.
3. Clean the ratios that do not make sense (negative Equity or EBITDA).
4. Normalize the ratios by sector, so that they are comparable.
5. Divide the stocks into quintiles according to the value of their normalized ratio.
6. Construct five equally weighted portfolios with the components of each quintile.

Results

Figure 2 shows the cumulative return of each portfolio (the most indebted companies are those in quintile 1 —red line—, and the least indebted are those in quintile 5 —dark green line—):

We see that in both cases it is confirmed that in the long term the most indebted companies have a lower return than less indebted companies. Although we see that the Net Debt-to-EBITDA ratio manages to better differentiate between the two (greater spread between quintile 1 and 5).

But what is more curious is that if we analyze the results of each quintile taking only the period from 2012 to 2022 (last 10Y), the Debt-to-Equity ratio fails to correctly identify those assets with higher leverage:

One potential explanation for this loss of alpha may be the popularization of buybacks in recent years. This has caused a greater number of companies to allocate a large part of their cash flow to repurchase shares, thus reducing their Equity and, therefore, distorting its Debt-to-Equity ratio.

In contrast, the Net Debt-to-EBITDA quintiles stats are consistent over time, and show greater linearity and robustness in the results:

In Figure 4 we see very clearly how assets with higher debt (quintile 1) have much more risk (higher volatility, higher drawdown, higher beta) than low-debt assets. Moreover, they have lower returns, and therefore lower Sharpe ratio and lower Alpha.

Conclusions

• The Debt-to-Equity ratio is less predictive than the Net Debt-to-EBITDA ratio.
• The superiority of the Net Debt-to-EBITDA is much more evident in recent years, due to the distortion produced by the buybacks in the Debt-to-Equity ratios.
• High-debt companies perform consistently worse than low-debt/net-cash companies.