Debt ratios offer several important insights into a company's financial health. They reveal how much a company relies on debt to finance its operations, how well companies can handle economic turbulence and they standardize important debt management metrics to show how companies compare with their competitors. For a large-cap telecommunications company such as Verizon Communications Inc. (NYSE: VZ), it's important to observe the debt-to-equity (D/E) ratio, interest coverage ratio and cash flow-to-debt ratio.
The D/E ratio reveals how a company is financing its asset purchases. A high ratio indicates a company is relying heavily on debt, and most of its money to purchase assets comes from creditors and lenders, not shareholders. Conversely, a low D/E ratio means a company raises money to purchase assets mostly by issuing stock and acquiring investment dollars.
Using leverage, or debt, to purchase assets is not an inherently bad thing, but it is comforting to know a company achieved its size and stature through attracting investors rather than borrowing money. For this reason, value investors in particular look for companies with D/E ratios lower than one, which indicates the company relies more on equity financing than debt financing.
Verizon's D/E ratio was eight for the quarter ending in September 2015. This figure has risen substantially in the past decade. Its equity has fallen by two-thirds over the last five years, while its total debt has risen by 25%. The company is highly leveraged compared to its competitors, including AT&T at 0.98 and T-Mobile at 1.36.
Interest Coverage Ratio
Because Verizon has increased its leverage so substantially in recent years, it is important to know the company is capable of servicing the interest on that debt. The interest coverage ratio calculates how many times over a company's current earnings can pay the interest on its outstanding debt. The higher the number, the better, with most fundamental analysts requiring a 1.5 or higher figure to feel comfortable.
Verizon's trailing 12-month interest coverage ratio is 4.14. While not a spectacular figure, it does indicate the company should face little trouble in the short term making interest payments. Not surprisingly, its interest coverage ratio has fallen substantially in recent years as its debt load has increased, though the ratio is still higher than that of AT&T or T-Mobile, despite Verizon being much more leveraged. This is because its earnings are much stronger than either of its major competitors.
Cash Flow-to-Debt Ratio
The cash flow-to-debt ratio is also important for a company that is highly leveraged. It indicates the percentage of total debt a company can retire with its current operating cash flow. Verizon's trailing 12-month operating cash flow is $35.9 billion, compared to its $228.9 billion in total liabilities. Therefore, its cash flow-to-debt ratio is 0.16, which is higher than AT&T's 0.12 and T-Mobile's 0.11.
Verizon has increased its debt load in recent years to expand its operations and improve its network. While increasing debt is something investors should monitor, Verizon demonstrates with its interest coverage ratio and cash flow-to-debt ratio that it has the earnings and cash flow to take on more debt safely and without risking its solvency.