This series of articles will delve into one of the more notorious and controversial aspects of analysis – that of debt and debt financing. Debt, if used well, can help a company to grow quickly and to scale up to match its competition. But if used unwisely, it can weigh down a company’s cash flows and may eventually cause it to go bankrupt. So how do we, as investors, assess if debt is too little or too much? Which ratios should we be looking at?
To start off, let’s define what debt is. Debt is incurred when a company takes a loan (i.e. borrows money), either from the bank or an individual (known as a lender). Interest has to be charged on the loan, and this is known as the “cost of financing”. Interest rates can range from anywhere between 1% (cheap loans) to 10% or more (expensive debt).
There are several ways in which a company can borrow money, the easiest being from banks or shareholders (known as shareholder loans), and the toughest being the issuance of notes, bonds and debentures in the stock market. The latter is known as “debt financing”.
Measuring debt levels
There are a few metrics which are commonly used to measure the debt levels of a company. The most common is the debt-equity ratio, or DER, which I wrote about in an article some time back.
Another metric to use is the “times interest earned” or “interest coverage” ratio. This ratio is used to calculate how well a company can service its debt obligations. The formula is the operating profit (EBIT) of a company divided by the total interest paid on all its debt and debt obligations. The higher this ratio is, the better the company can service its debts and the “safer” it is.
Yet another useful ratio is the “Net Debt to EBITDA” ratio, which is computed by taking the total cash minus total debt to get net debt, and then dividing this figure by EBITDA (earnings before interest, taxes, depreciation and amortisation). This is a quick calculation to show how many years it would take the company to pay back all of its debt. The ratio can be negative if the company has more cash than debt, and this is obviously a positive trait.
The next article in this series will look at capital expenditures and the importance of these in fast-growing companies, and also how it impacts free-cash-flow calculations.
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