Course 405: Classic-Growth Stocks
Is the Company's Debt Leverage Increasing?
In this course
1 Introduction
2 How Fast Has It Been Growing?
3 What Are the Trends in Growth Rates?
4 Where Is Growth Coming From?
5 Is Profitability Keeping Pace with Growth?
6 What Is the Company Doing with Its Profits?
7 Is the Company's Debt Leverage Increasing?
8 How Has the Stock Performed?
9 How Do the Stock's Price Valuations Compare with Those of Similar Firms?
10 Conclusion: Quality versus Price

Classic-growth companies, with their solid and often noncyclical businesses, generally have a lot of room for debt. Reliable sales and operations mean that most of these companies don't have trouble making debt payments, so a high ratio of debt to equity is likely not a problem. Debt that is rising relative to assets or equity is something to look out for, however. For one, increasing debt means more volatile earnings because the larger interest payments on the debt magnify even small swings in earnings. Also, companies can prop up their profitability by taking on more debt leverage. Because financial leverage is one of the drivers of ROE, a firm can raise its ROE simply by borrowing more. Such a company may get a higher ROE, but the quality of that ROE will be lower. Worse, financial leverage can disguise a decline in net margins or asset turnover, the two other drivers of ROE that are more indicative of a company's operational health. As of late 1999, McDonald's financial leverage was 2.2, which is somewhat high compared to the classic-growth average. However, the company's level of debt has been fairly stable over the past five years, with financial leverage around 2.0. McDonald's debt level is not ideal, but neither is it a reason to worry.

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