Debt ratios help investors analyze a company's ability to pay the principal and interest on its outstanding debt. The ratios reveal how a company finances its asset purchases and its ability to withstand economic turbulence. They also indicate whether the company is using debt responsibly to grow its business or if it is relying excessively on debt to meet core obligations. The latter could imply there is trouble looming in the near future.
Certain debt ratios should be compared to benchmarks while others are more subjective and are better compared to the ratios of industry peers and the broader market. For a large-cap retailer such as Walmart (WMT), the most reliable debt ratios to evaluate are the debt-to-equity ratio, interest coverage ratio, and cash flow-to-debt ratio.
- Investors use debt ratios to analyze how a company finances its asset purchases and the company's ability to pay its outstanding debt.
- Three debt ratios commonly used to evaluate a company are the debt-to-equity ratio, interest coverage ratio, and cash flow-to-debt ratio.
- A high debt-to-equity ratio indicates a company relies on debt as opposed to equity to finance its asset purchases.
- As of Oct. 31, 2020, Walmart's debt-to-equity ratio was 1.87, a figure signaling the company was using more debt than equity to finance its asset purchases.
The debt-to-equity (D/E) ratio compares the percentage of a company's assets financed by debt versus equity, calculated as total liabilities divided by total shareholders' equity. A high D/E ratio suggests a company is more leveraged and reliant on debt to finance asset purchases. While using leverage is not an inherently bad thing, using too much leverage can place a company in a precarious position.
Walmart's D/E ratio as of Oct. 31, 2020, was 1.87. This is a healthy figure that has remained remarkably steady over the past decade. It indicates the company is using more debt than equity to finance asset purchases, but its debt management practices have not wavered for several years, and the company refrained from using excess debt even during an economically turbulent period.
Compared with its key competitor, Walmart has a lower D/E ratio, where Target's ratio was 2.8 for its fiscal quarter ending Oct. 31, 2020.
Interest Coverage Ratio
The interest coverage ratio measures how many times a company can pay the interest on its outstanding debt with its current earnings. It's calculated as earnings before interest and taxes (EBIT) divided by interest expense.
A high ratio means a company is not likely to default on debt obligations in the near future. Most analysts agree the absolute lowest acceptable interest coverage ratio is 1.5, although value investors prefer companies with a significantly higher number.
Walmart's interest coverage ratio was 10.7 for the fiscal third quarter of 2020. Walmart's interest coverage ratio started falling drastically in 2017 before bottoming in in late 2018 and has since rebounded to multi-year highs as of Jan. 2021. The decline was due to a drop-off in EBIT. For Target, it's interest coverage ratio was 3.1 for the same quarter. For the first nine months of 2020, Walmart's interest coverage ratio was 9.5. Meanwhile, Target's was 5.4 for the same period. Overall, Walmart has more EBIT to cover interest expenses.
Cash Flow-to-Debt Ratio
The cash flow-to-debt ratio, calculated as cash flow from operations divided by total debt, measures the percentage of a company's total debt it can pay with its current cash flow. This is an effective metric to consider along with the interest coverage ratio because it includes only earnings that have actually materialized in cash.
This measure is best calculated using full-year data. Thus, in the fiscal year 2020 (ending Jan. 1, 2020) Walmart's cash flow-to-debt ratio was 0.58, meaning its annual current cash flow from operations could pay 58% of its debt. It will be important to watch this trend in the future as an indicator of the company's commitment to responsible debt management. Target had a cash flow-to-debt ratio of 0.63 for the fiscal year 2020 (ending Feb. 1, 2020).