Education: Growth & Income Investing
Companies basically have two ways to raise capital (money) for expansion, acquisitions or to finance other operations. They can issue stock in a public offering, by selling part of the company, or they can borrow the money by issuing bonds. Equity financing (issuing stock) is advantageous for a company mainly because nothing has to be paid back and interest payments can be avoided. Alternatively, debt financing (issuing bonds) creates a liability for a company. At what point should investors be concerned that a company may be borrowing too much?
Ratios to the Rescue
Should companies that carry large levels of debt be avoided like the plague? Okay, cheap answer time: it depends. Don’t worry; I won’t leave it at that. It does truly depend on the company and the industry it participates in. For industries that require a higher level of borrowing in order to conduct business, large amounts of debt on the books is not necessarily a bad thing.
Lucky for you there are several tools that can be utilized to help determine whether or not a company is taking on too much debt.
Debt to Equity Ratio
The debt to equity ratio measures what proportion of equity and debt a company is using to raise money, and is calculated as follows:
Debt/Equity Ratio = Total Liabilities/Shareholder’s Equity
Both total liabilities and shareholder’s equity can be taken directly from a company’s balance sheet—yep, it’s that simple. At www.zacks.com we provide both of the figures for you free of charge. As you can probably deduce, a number greater than one indicates that more debt than equity is currently being used by the company. In a nutshell, the higher the number, the higher the level of debt. But at what level should a red flag should be raised?
It is always a good idea, when using any ratio, to make comparisons to other firms in the same industry, or to the industry as a whole. Is it borrowing more than its peers? Or is it in line with the industry average? Good questions to ask yourself.
With debt come interest payments. With this being said, a ratio that helps an investor determine just how successful a company has been meeting its interest payments would come in handy. Introducing…the interest coverage ratio, which is calculated as follows:
Interest Coverage Ratio = EBITA/Interest Expense
EBITDA is short for earnings before interest, taxes, depreciation and amortization (wow that’s a mouthful). The earnings, tax and interest figures are found on the income statement, while the depreciation and amortization figures can usually be located in the notes to operating profit or on the cash flow statement.
It is typically recommended that companies maintain an interest coverage ratio of 1.5 or greater. This usually signifies that a company is producing enough cash to meet its interest obligations.
The current ratio, also sometimes referred to as the liquidity ratio or the cash ratio, gives an investor insight into a company's ability to meet its short-term debt obligations and is calculated as follows:
Current Ratio = Current Assets/Current Liabilities
As with the interest coverage ratio, the higher the current ratio, the better. If current liabilities exceed current assets (resulting in a ratio less than one), then the company may have problems meeting its short-term obligations. Both figures used in the calculation can be retrieved from a company’s balance sheet.
Other Areas to Explore
If a company is taking on more and more debt, it would be in your best interest to dig deeper and try to uncover exactly what it is trying to accomplish by doing so. New projects or acquisitions that have the potential to increase earnings are obviously good reasons to issue more debt, provided the company can meet these added liabilities. However, if more debt is issued with the intent being to help pay off previous debt, this should cause you to be a bit alarmed.
Moreover, what makes up a company’s debt portfolio? Is it loaded with long-term or short-term debt? And by using the ratios discussed above, will the company be able to survive both in the short term as well as in the long term?
You have to remember that when a company misuses its debt in one way or another, its earnings are bound to suffer. And being the dedicated Zacks fan that you are, you know that earnings drive stock performance.
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