When you think about how to evaluate a company, there are various aspects that need to be assessed. These include studying the assets and liabilities of the company that provides a quick view of its financial health and its debt situation.
All businesses need financing at some point. It can be for expansion or to manage operational costs due to some unexpected turn of events (like the current pandemic).
Debt and equity are usually the two options that companies look at when they need to raise capital. While equity capital does not attract interest, issuing shares can be a complex and time-consuming process.
And so, most companies look for a healthy mix of equity and debt to raise capital. Today, we will be focusing on debt analysis and look at how you can analyze a company’s debt management ability.
But, why is analyzing debt so important?
There are many reasons:
- A company can have more debt than its assets. Surprisingly, right? In fact, you will find many companies with this equation. This is not necessarily a bad thing unless the company is unable to manage its liabilities.
- A debt attracts interest. Hence, higher debt and/or longer tenure implies more money lost towards interest payment. This affects the profitability and growth of the company.
In this article
- Financial Ratios For Debt Analysis
- What Do All These Ratios Mean?
- How Debt Affects the Intrinsic Value of a Company?
Financial Ratios For Debt Analysis
Here are some ways to analyze the ability of a company to manage its debt:
1. Interest Coverage Ratio or Times Interest Earned
One of the first things that you need to check to analyze a company’s debt management ability is if its operating profits can cover the interest charges comfortably. In simpler terms, can the company pay interest on its debt?
You can use a simple formula to measure this called Interest Coverage Ratio (ICR) or Times Interest Earned as shown below:
You can find EBIT (Earnings before interest and taxes) and Interest expense on the income statement of the company.
If ICR is very low (below 1), then there is a risk of the company defaulting on its debt. This should be a warning sign for investors planning to purchase their shares. On the other hand, if ICR is too high, then it could indicate that the company is playing too safe and probably missing opportunities of availing more debt and boosting its growth.
2. Fixed Charge Coverage
Apart from the interest on the debt, a company can also have other fixed charges like leases, etc. Analyzing if a company can manage all it fixed charges is important if you find that it has high fixed charges apart from interest on the debt. Here is how you can calculate it:
Fixed Charge Coverage=(EBIT+Fixed Charges before tax)/ (Interest expense+ Fixed Charges before tax)
You can find EBIT, interest expense, and fixed charges from the income statement of the company.
3. Debt Ratio
One of the simplest ways to assess whether a company might default on its debts is by looking at its Debt Ratio. Before investing in a company, you must ensure that it is worth your investment and has enough assets to manage its liabilities with ease. The debt ratio can be calculated by using a simple formula:
Debt Ratio =Total liabilities / Total assets
You can find total liabilities and assets in the balance sheet of the company. This ratio will give you an understanding of the percentage of the company’s assets that were funded by incurring debt. So, if the company has a debt ratio of more than one, then it implies that it has more debt than the worth of all its assets. Hence, the risk of default is high. Typically, investors prefer companies with a debt ratio of less than one.
4. Debt to Equity (D/E) Ratio
Apart from assessing the ratio of liabilities to assets, it is also important to measure the ratio of the company’s debt to its equity. If you observe a trend of increasing D/E ratio, then it usually indicates that the company’s profits are insufficient to sustain its operations and it is making up for the shortfall with debts. Here is the equation:
D/E Ratio =Total liabilities / Stockholder’s equity
You can find the liabilities and stockholder’s equity figures in the balance sheet of the company. While analyzing the D/E ratio of a company, you must factor in the ICR too as explained below:
- D/E Ratio is high and ICR is low – This implies that the company has been too reliant on debt funding to manage its operations. Hence, it might have a difficult time repaying its debts.
- D/E Ratio is high and ICR is high – This implies that the company has been using additional debt to boost its earnings and profitability.
- D/E Ratio is low – This implies a lower risk of loan default.
While usually, investors prefer companies with a low D/E ratio, a company with higher debts accompanied by a corresponding increase in ICR will lead to an increase in the value of equity and balance the D/E ratio in the long run. Analyze carefully.
5. Debt to Tangible Net Worth Ratio
In the extreme case of a company getting bought by an investor who plans to sell off the assets and move out of business, physical or tangible assets would be the ones sold since intellectual property cannot be sold while liquidating a company.
Hence, knowing the debt to tangible net worth ratio can help you assess if the company has more debt than it could pay off by selling all its physical assets or not. The formula is as given below:
Debt to Tangible Net Worth Ratio = Total liabilities / (Stockholder’s equity–Intangible assets)
You can find the value of total liabilities, stockholder’s equity, and intangible assets in the company’s balance sheet. If the ratio is less than one, then the company could pay off all its debts by liquidating its physical assets and still have some funds left over. Such companies are at less risk of default.
6. Operating Cash Flows to Total Debt Ratio
While debt to tangible net worth ratio allows you to assess if the company has sufficient physical assets to pay off its debts, a company doesn’t prefer doing. This is because any company selling its assets to pay off its debts sends a clear signal to the market that it is in troubled waters. Hence, as an investor, it is also important to assess the company’s ability to pay its debts without selling any assets. This is measured by using the Operating Cash Flows to Total Debt ratio as shown below:
Operating Cash Flows to Total Debt Ratio=Operating Cash Flows / Total Debt
Both these figures are available on the balance sheet of the company. If a company has a high ratio, then it can easily pay off its debts without selling any of its assets. On the other hand, a low ratio implies the possibility of selling assets for debt repayment.
What Do All These Ratios Mean?
The ratios described above can help you understand how efficiently the company is managing its debts. Here is a quick snapshot:
- ICR – Are operating profits enough to manage the interest expense?
- Fixed-charge coverage – Can the company manage its fixed charges over and above the interest expense?
- Debt Ratio – What percentage of the company’s assets are funded using debt?
- D/E Ratio – How is the company balancing funding through equity and debt?
- Debt to tangible net worth ratio – Can the company pay off all its debt by selling its physical assets?
- Operation cash flows to total debt ratio – Can the company pay off its debts without selling assets?
A company can avail of different types of debt like operating and/or capital leases, trade financing, bank loans, lines of credit, etc. Usually, a company’s debt is divided into two categories:
- Short-term debt
- Long-term debt
It is important to assess these separately as they impact the company’s financials in different ways.
How Debt Affects the Intrinsic Value of a Company?
Calculating the intrinsic value of a company is simple – you take the total assets of a company and subtract the total liabilities from it. Then, divide the result by the number of outstanding shares. The answer will be the intrinsic net worth of the company.
If the company is borrowing regularly, then its debt is increasing. If the company can use the borrowed funds or assets to increase revenues and profitability at a rate higher than the interest rate of the debt, then it can maintain a healthy financial condition. Else, its intrinsic value will start dropping.
Remember, analyzing the debt management ability of a company is crucial to help understand the financial strength of the company and its implied ability to weather economic storms. In fact, even if a company has a low debt ratio, if it isn’t managing its debts optimally, its growth trajectory can get affected. So, ensure that you follow the tips mentioned in this article and analyze the company’s debt management ability carefully before investing.
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