With economists and market strategists talking about a possible recession, inves-tors may want to prepare for an economic hurricane season in case these forecasts prove to be correct.

A company’s balance sheet can provide a strong foundation when economic winds become harsh and blow the wrong way.

The main problem for a company experiencing a drop in revenue and cash flow is its debt obligations. How much does it owe? Does it have a margin of safety? There are shorthand measurements for comparing risk. Most common is the debt/equity ratio and the ratio of cash flow to debt.

The table at right highlights a third measurement of strength — the relationship between a firm’s shareholders’ equity and its total assets. This is a straight balance-sheet analysis, but one that is not commonly used. The equity/assets ratio is useful because every company reports assets and common equity, but some have no debt, making the debt/equity and cash flow/debt ratios useless.

None of these ratios use stock price, eliminating an extraneous influence on the results. The ratios separate companies that are well cushioned against exhausting their financial and other resources from those that are at risk. What the market pays for one or another, however, is a separate matter.

The first rule in balance-sheet strength says a company should owe less in long-term debt than it has in shareholders’ equity. Companies that have little debt vs equity are better insulated from failure.

A potential flaw in this measurement is the definition of “long-term” debt. On some balance sheets, there are substantial long-term obligations, such as leases and tax payments, apart from formal debt. In place of funded long-term debt, “total debt” is used, but it can be awkward to calculate.

The work of Edward L. Altman of New York University shows that cash flow/long-term debt (or total debt) is significant in predicting corporate failure. Altman’s “Z factor” analysis is the sum of a range of ratios, of which cash flow/debt has the heaviest weighting.

The case for the equity/assets analysis goes this way, in the words of accounting professor Charles J. Woelfel in his book, Financial Statement Analysis: “If the shareholders’ equity is a small proportion of total assets, the firm may be viewed as being financially weak because shareholders would be viewed as having a relatively small investment in the firm.

“A high ratio … can represent a relatively high degree of security for the firm, but also indicates the firm is not highly leveraged.”

A single ratio is not the be-all and end-all in financial analysis, but the equity/assets ratio is a first step in examining a balance sheet. And it’s not foolproof. Like every single-ratio analysis, it requires work to verify what may seem attractive or unattractive.

Ratio ranges vary. You won’t find financial stocks in the accompanying table because they characteristically have a low ratio of equity to assets and must be compared against one another. For insurers, for example, the ratio is generally in the 7%-11% range. The range for banks is even lower.

A typical result is for Power Corp., which shows equity equalling only 6% of assets, but otherwise it is the financial powerhouse its name suggests: it has much less debt than equity and 1.3 times cash flow coverage of its debt.

The equity/assets ratio is an important measurement of risk for banks. Historically, Canadian banks’ price/earnings multiple has gained and dropped in line with the equity/assets ratio. For banks, however, the ratio is much smaller than for other industries. Since the 1960s, the ratio has ranged between 3% and 5.5% of equity/assets, according to analyst Kevin Choquette in the Handbook of Canadian Security Analysis.

Canadian Western Bank has the highest ratio, based on its latest fiscal yearend, with equity forming 7% of assets. For the Big Six chartered banks, the ratio is 4% or 5%.

If there are surprises in the table, they are among resources stocks. Their industries are volatile and debt levels often oppressive in business downturns. But a number of companies reveal surprising balance-sheet strength. Senior energy stocks miss inclusion in the table because their equity/asset ratios are typically about 50%.

Big asset-management and private-equity firms, such as Onex Corp. , score poorly in balance-sheet analysis, with low equity/debt ratios and high debt/equity ratios.

The firms surveyed to produce the accompanying table are not all-inclusive. Other sturdy balance sheets may be discovered. IE

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Note: Carlyle Dunbar may own securities discussed in this article.