For a large-cap industry leader such as General Electric (NYSE: GE), the most important debt ratios to analyze when conducting fundamental analysis are the debt-to-equity (D/E) ratio, the interest coverage ratio and the cash flow to debt ratio.
These ratios offer important clues about the company's financial position. The D/E ratio considers the company's assets and compares the percentage purchased through debt financing to the percentage purchased through asset financing. The interest coverage ratio compares the company's current earnings to the total interest on its outstanding debt. Lastly, the cash flow ratio looks only at the actual cash the company receives from its operations and calculates what percentage of its total debt that cash is capable of retiring.
Because these figures are ratios, they are standardized and are easy to compare to industry competitors and broader market averages.
GE's D/E ratio for the quarter ending in September 2015 is 1.76. In other words, the company has utilized 76% more debt than equity to finance asset purchases. This figure has trended downward significantly in the last few years, as it stood at 3.15 in 2008. However, the company's D/E ratio still ranks higher than most of its major competitors in the large-cap conglomerate industry, including the 3M Company and Honeywell International. Unlike GE, both of these companies use significantly more equity financing than debt financing. 3M's D/E ratio stands at 0.74, while Honeywell's is 0.32.
When a large-cap company employs a high degree of debt financing, fundamental analysts should ensure that the company has the means to service that debt. Leverage can be a fantastic way for a company to expand, particularly during an expansionary phase in the economic cycle when spending is up and revenues are strong. High debt tends to hurt companies during the ensuing contractionary phase, when earnings and cash flow diminish.
The interest coverage ratio compares earnings to interest due and indicates how much cushion a company has when it comes to paying the interest on its debt. A high multiple is a good sign, as it offers breathing room if earnings decline in a down economy.
GE's interest coverage ratio for the 12-month period ending in September 2015 is 2.46. While this is higher than the 1.5 benchmark that fundamental analysts consider to be the minimum acceptable level, it is not a figure that should inspire tremendous confidence, particularly from conservative investors. Moreover, GE's interest coverage ratio is significantly lower than that of 3M (52.46) and Honeywell (21.25).
Many fundamental analysts consider the cash flow to debt ratio to be even more crucial than the interest coverage ratio. While the interest coverage ratio considers all earnings, including receivables and revenue that may not yet be realized, the cash flow to debt ratio considers only cash the company has on hand from its operations. The ratio compares this cash to the total debt outstanding. Investors like to see operational cash flow in excess of 10% of the company's total debt.
GE's cash flow to debt ratio has trended moderately downward in recent years and currently stands at 0.05. The company's operational cash flow covers only 5% of its total debt. 3M (0.3) and Honeywell (0.18) have much higher cash flow to debt ratios.
GE's debt picture leaves a lot to be desired, though the company's overall fundamentals are much more attractive. GE's revenue increased by over 20% from 2014 to 2015. It is valued appropriately, with a price-earnings (P/E) ratio of 15, and its stock price rose by over 14% during a period when the S&P shed 10%.