Ask Colin

I have found a company that meets all the "margin of safety" tests, except that it has a debt to equity ratio of 220%. How should I deal with it?

First, let me tell you a story about Jack Tilburn, scourge of company chairmen.

Jack got up years ago in the TNT annual general meeting and started by telling the chairman how he had just done the Securities Institute course on financial statement analysis. In it he had learned that a debt to equity ratio should not be over 100% in a soundly financed company. He then pointed out that he had calculated the TNT debt to equity ratio at 120% and what did the chairman say to that?

The chairman was Fred Millar. Fred rose to his feet and referred Jack to the relevant page in the annual report that showed the ten year summary of financial data. He pointed out that 120% was the lowest that the TNT debt to equity ratio had been in the whole ten years. He then observed that "We still seem to be in business".

The point is that different businesses can support different ratios. So, you are going to have to do some more work. I would be looking at the history for that company (which Jack had not researched) and also at other competitor companies if you can find them.

You may find that there is an unusual situation. For example, in the mini course, I use Funtastic as an example. It had a high ratio. However, the directors had gone to some trouble to point out it was seasonal and that their projections of cash flow saw it back to normal in three or four months.

This sort of thing can also be checked with the company. Ring them up and talk to the Comany Secretary or Investor Relations Manager. Remember they will put the best light on it that they can. Listen to how candid they are.

Finally, this is a high ratio. I would need to be convinced very strongly that it was OK. If in doubt, keep looking for other investment opportunities. Or wait until the ratio is back in the safe zone.

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