Debt on the balance sheet of the company is always bad and can it be a good deal to have some portion of debt in the business. So, let’s get started!
Why Do Companies Require Debt:
- Certain sectors by nature are capital intensive. This means that a certain company’s business model inherently requires a high infusion of cash which is not possible to be financed using equity. Some of such sectors are steel, hospitals, etc.
- The cost of debt is generally much lesser than the cost of equity.
- Raising debt does not require dilution of control.
- Debt helps in saving taxes. The interest cost on debt is a tax-deductible expense. Hence, due to interest cost, the taxes are lower and the existing holders of equity as a result get higher returns on equity keeping all other things constant.
How to understand the debt profile of a company:
Interest Coverage Ratio:
The interest coverage ratio is a ratio that measures how easily can the company service the interest cost on its debt compared to the earnings generated by the business.
The formula for interest coverage ratio is as under:
Interest coverage ratio = EBIT / Interest expense
*EBIT -> Earning Before Interest and Tax
- Higher the ratio, the better position the company is in service of the interest cost on the debt.
- The financial position of the company can be said to be critical if this ratio is less than 1 since this means the company is not generating enough profits to pay the interest on the debt. It is also important to analyze this ratio over some time rather than used it as a single period analysis tool.
Debt to Equity (D/E) Ratio:
The debt Equity ratio is a financial leverage evaluation metric that compares the level of debt on a company’s balance sheet to the net worth or the equity in the books of the company.
The formula for the Debt to Equity ratio is:
Debt to equity = Total Liabilities / Total Shareholders’ Equity
- A high D/E Ratio is often equated with high risk. This is because a higher ratio signifies that it is more and more likely that the company might not be able to pay off its debt obligations which could result in default.
- Generally, a debt-equity ratio of more than 2 signifies high risk. Conversely, a debt-equity ratio of 0 means that the company is debt-free.
Is having debt on the balance sheet always bad?
No, if that the cost of debt is much lower for the company and the company is already generating high cash flows from its operations
What Should Investors Look For?
As an investor, one must ask themselves the following questions to determine if the company they are investing in is a risky investment or not from a debt point of view
- What is the quantum of debt in comparison to the net worth of the company?
- What is the debt being used for and what could be the incremental benefits to the company through the investment made through debt? In most cases, debt is used by companies to finance capacity expansions. In such a case, it must be evaluated whether the company needs a capital expansion considering the current utilization limits and whether the expansion can result in increased future cash flows from operations?
- What is the revenue visibility of the company? This is important because for the debt to be repaid, it is important that the company generates sufficient revenue in the future and there are no major issues regarding the future revenue visibility.
What Should Investors Do?
Having debt on the balance sheet is not necessarily bad from an investor’s point of view. However, what mainly matters is the quantum of the debt and the ability of the company to repay it. As an Investor, one should check how much is the debt of the company, it should not be high and should be in the ideal range