How to analyse company debt
Iwrite a lot about debt and am consistently checking company debt levels for a simple reason ‒ debt is a classic t wo-edged sword. Used correctly, it can help a company grow but on the f lip side, if it’s abused or managed poorly, it can hurt growth or even lead to the bankruptcy of a company.
The key point of debt is that if a company is borrowing money that it can afford to pay back and the loan ultimately adds extra revenue and profit ahead of the cost of the debt, it is a good deal. So, as an example, it would be great if a company borrowed money at say 10% that led to an increase of 15% in profits.
Debt is also the preferred way to raise money; other options such as rights issues are problematic as new shares are issued and essentially you’re paying for that new money forever by way of the new shares that have a permanent claim on future profits and dividends. In other words, the extra shares exist forever whereas debt can be paid back.
So given that debt is a useful but potentially dangerous tool, how do we monitor it and ensure a company’s debt is not life-threatening?
Firstly, we would check the balance sheet. Debt will be listed on the liability side either as current (due within the next 12 months) or non-current (due after the next 12 months).
The f i gure for current debt i s important as the company will have to pay it back or roll it over via a new loan and the question is whether the company can manage one or the other.
We will also sometimes see some debt sitting in an overdraft facility. This I don’t like one bit. Firstly, an overdraft is expensive debt in that it will be at a high interest rate; secondly it can be called at any stage (in other words the lender can request immediate repayment). The problem with this type of debt is why it was taken out in the first place. Overdraft debt suggests the company needed some cash in a hurry and rather than (or perhaps unable to) borrow money, it simply ran up an overdraft. This suggests either a crisis or lack of planning.
SO NOW THAT WE KNOW WHERE THE DEBT IS, HOW DO WE LOOK AT IT AND WHAT RATIOS SHOULD WE USE?
Certainly the preferred ratio for debt is the debt-to-equity (D/E) ratio or the netdebt-to-equity ratio. This is simple the equity on the balance sheet (remember equity is all assets less all liabilities) into which we divide debt.
The second version is net debt – here one would remove any cash the company holds from the debt on the assumption that this gives a clearer picture. While in theory cash can be used for paying off debt, it may have other uses. That said, typically I look at both.
I then compare a company’s ratios to industry peers and the own company’s previous levels. This now tells you how its current debt situation stacks up.
The a nnual r epor t i s a nother important document as it will give a lot more detail on the debt a company has. Payment dates and interest rates will be provided and the former is very important. If a company has a lot of debt expiring in say two years’ time, what is the plan? Will it roll the debt over into a new loan or is the company planning to pay it off?
As a last point, debt should ideally be project-specific. I prefer when debt is raised specif ically for a project or acquisition rather than when a company just borrows a large sum for no specific purpose. This makes it easier for shareholders to see if going into debt in that specific case was ultimately worth it or not.