Some Investors Keep Making This Ford Mistake

Metrics and ratios can be great. They take complex information and present it in a form that allows you to make comparisons between competitors or industries. They can give you valuable insight into the company’s performance and whether management is improving certain aspects of the business. But they can also give you the wrong idea if you don’t have the proper context or understanding. I recently encountered a misunderstanding related to Ford automobile companyIt is (NYSE:F) debt ratio – here’s what it was and what you can learn from it.

What happened?

I recently came across an article that said something like: “Ford uses its large debt load to improve its returns. Its debt-to-equity ratio is incredibly high at 3.46.” While this figure is technically accurate, the analysis is unacceptably flawed.

To begin, let’s better explain the debt ratio and why Ford’s inputs need to be adjusted. The debt-to-equity ratio (D/E) assesses a company’s financial leverage and is calculated by dividing total liabilities by shareholders’ equity.

The D/E ratio can be used to assess a company’s reliance on debt and is best used in comparison within an industry, as results may move differently across industries. A higher D/E ratio suggests that a company is taking more risk by taking on more debt, but it can work the other way if a company has a low D/E and has more to gain by taking on debt and by investing in the growth of your business.

How to adjust

Ford’s D/E ratio of 3.46 represents Ford’s total liabilities, which include debt from Ford Credit, Ford’s financial arm. Before we go any further, let’s look at Ford Credit’s contribution.

Ford Credit takes on massive debt, like a bank, and offers consumers loans and leases and supports dealership renovations, among other things. Essentially, Ford Credit takes on massive debt but makes it a very profitable business. Ford credit is often more profitable than any other Ford region outside of North America.

Now let’s modify this ratio to better see the difference between the debt including and without the Ford credit. Let’s just use total long-term debt, auto debt, and total equity from Q2.

Using only long-term debt, we get a formula of $100.3 billion divided by $43.6 billion, or a D/E of 2.3 times. Consider that anything above 2 enters dangerous territory, in many industries. One could take a look at some indicators and immediately conclude that Ford has too much debt and is taking too much risk.

However, when you write off Ford Credit’s debt – which, again, is a huge benefit to the company’s bottom line, not a hindrance – and use only auto debt, the ratio reduces to a much more reasonable rate of 0.42 times. This is a marked difference in how you view Ford and its metrics, based solely on understanding Ford’s core business and how it overlaps with Ford Credit.

What it all means

It just reminds you that you should always check the numbers and do your own research. And while indicators are incredibly useful, they also require context and understanding. Ford Credit is a very important entity to Ford and its underlying business, and given how it operates, its debt should not be included in certain ratios.

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Daniel Miller holds positions within Ford Motor Company. The Motley Fool has no position in any of the securities mentioned. The Motley Fool has a disclosure policy.