How to an­a­lyse com­pany debt

Finweek English Edition - - INVEST DIY -

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.


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.

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