Debt-equity ratios prepared using traditional (GAAP) accounting numbers can mislead unwary analysts. In many cases, the necessary adjustments will result in substantially reduced debt-equity ratios. LIFO balance sheets, for example, often show inventories based on prices that, in today’s inflationary environment, are far below current market. Marketable securities are often carried at values below current market and, although there are exceptions, the current value of plant usually exceeds the balance sheet cost. Finally, the reserve for deferred taxes usually includes differences between reported and taxable income that will never reverse.
On the other hand, the necessary adjustments to leases, pensions and unconsolidated subsidiaries may increase debt-equity ratios. Up to now, many leases with all the characteristics of debt have not been recognized as such on the balance sheet; their recognition will increase debt without affecting equity. Because they constitute an interest-bearing liability of the corporation, unfunded pension benefits also belong on the balance sheet—albeit with an offsetting adjustment for taxes. And the effect on the parent’s debt-equity ratio of consolidating subsidiaries’ debt is clearly unfavorable.
The authors demonstrate the effect of the individual adjustments on the debt-equity ratios of Penney’s, Sears, G.M., Zenith and Kodak, and present adjusted debt-equity ratios for all 30 Dow Jones Industrials.