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http://TheValueatRisk.blogspot.com
 
November
 
3,
 
2009
 
Introduction
 
to
 
Credit
 
Risk
 
Analysis:
 
Debt
‐
to
‐
Equity
 
Ratio
 
If recent financial market events have taught us anything, it's that a) leverage can work bothways, and b) when leverage works against an individual/corporation/investment entity, theresults can be fairly disastrous. Although the pair of statements above are essentially commonlyheld knowledge, the behavior exhibited by market participants throughout the past 20 years wasnothing if not a blatant disregard for this reality. Moving forward, it will be more prudent thanever for investors to perform a sober assessment of a corporation's use of leverage.At the heart of credit risk analysis is a corporation's solvency, or in other words, it's ability tofunction as a going concern, capable of avoiding financial distress. The cornerstone ofevaluating solvency is the Debt-to-Equity Ratio, which as the name implies, looks at a firmsabsolute debt level in terms of a multiple of total stockholders' equity. Both parts of the equationcan be found on the balance sheet, and are plugged in as follows:Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' EquityVerizon's (VZ) Debt-to-Equity Ratio is calculated as follows:Debt-to-Equity Ratio = Total Liabilities / Total Stockholders' Equity= $160,646M / $41,706M= 3.85In other words, for every dollar of Shareholders' Equity, Verizon holds $3.85 worth of debt. Thisratio will obviously fluctuate greatly based upon the industry, and the composition of the firm'sfunding sources, i.e. relative breakdown of debt v equity funding. The chart below comparesVerizon with seven other large firms from a debt-to-equity ratio standpoint:
 
 
http://TheValueatRisk.blogspot.com
 
November
 
3,
 
2009
 
Clearly, the debt-to-equity ratio needs to be examined from within the context of the individualfirm and industry as a whole. For instance, there are two reasons why I wouldn't be alarmed atVerizon's high ratio of debt funding. First, it's subscriber based business provides relativelystable and predictable cash flows; a distinction that translates into ample access to the bondmarket. Secondly, a major portion of Verizon's borrowing activity over the past couple of yearshas been geared towards investment in it;s FiOs network. I haven't assessed that product froma consumer standpoint, but feel certain that Verizon will be able to leverage it's marketleadership position into a substantial FiOs subscriber base.Step 2 in the credit risk analysis process is determining the firm’s ability to cover interestpayments from internally generated cash. That ratio will be addressed in a future article.*no positions
 
Copyright
 
2009
‐
The
 
Value
 
at
 
Risk
 
of 00

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