Learn to Love Company Debt

 

Learn to love company debt! Well, up to a point. I see leverage through debt as a brilliant way for companies to create wealth. Most successful businesses use leverage to their advantage. Learn to understand debt and you’ll love it too.

Utilities, pipelines, and telecoms are perfect examples of how leverage can be used to the shareholders’ advantage. They operate capital-intensive business models; waiting to finance projects from cash flow would take them years during which their competition could hurt their market position. Therefore, they use debt to build long-term assets they expect will generate cash for decades.

If leveraged companies manage their debt effectively and invest in value-creating projects, they might receive more cash flow than they need, and be able to increase their dividend accordingly. That was easier to do when the banks’ money was cheap, which is no longer the case.

While we can use debt to boost our assets, not all debt is good nor do all leverage operations end well. Ignoring debt ratios because they’re boring or “too complicated” could leave you holding companies with too much debt on their books. When interest paid becomes a burden, bad news often follows, including layoffs, margin squeezes, and eventually dividend cuts.

Until Debt Tear Us Apart written on a brick wallTo manage your portfolio well, know the debt ratios of your holdings, and combine that knowledge with the dividend triangle analysis. You’ll likely avoid bad news and pick thriving companies that know how to use the bank’s money to promote good outcomes. See Detect Losers and Find Winners with The Dividend Triangle.

Debt Ratios and Financial Lingo

Since debt ratios and financial lingo don’t make a gripping read, I tried keeping the explanations simple. We’ll talk about two categories of financial ratios:  liquidity ratios and leverage ratios.

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Liquidity ratios

Liquidity ratios tell you if a company can afford to keep doing business. They determine the company’s ability to pay off current debt obligations without raising external capital (e.g., issuing shares or getting into additional debt). It’s pretty much the same as looking at your bank account balance before going to the restaurant.

We’ll look at three liquidity ratios: the Current, Quick, and Cash ratios. The current ratio is the most lenient; it considers all current assets. The quick ratio considers accounts receivable (makes sense since it’s incoming money) but discards inventory value. The cash ratio is harsher, considering cash and cash equivalents, nothing else.

Current Ratio

Commonly used, the current ratio determines the financial strength of a company’s balance sheet. Does it have enough assets to get through the quarter? Comparing a company’s current assets with its current liabilities quickly shows if there’s a short-term problem. I used the current ratio often during the 2020 market crash, to make sure companies in my portfolio had sufficient assets to get through the lockdown.

Current Assets / Current Liabilities

Obviously, we want to see more assets than liabilities. If the ratio is below 1, the company might run into financial problems sooner rather than later. Conversely, you don’t want too many current assets either. A ratio significantly over 1 can indicate poor management of assets; the company has too much cash and isn’t using it to create value.

Quick Ratio

The quick ratio is of great use during challenging times. It tells you if the company has enough cash or cash equivalents to pay its bills “at the end of the month”. Just like looking at your bank account and emergency fund to know if you can pay your mortgage, car payment, taxes, and utility bills. Unlike the current ratio, the quick ratio formula discards inventory on hand; it’s easy to be too generous with the inventory book value when things are going badly.

(Current Assets – Inventory) / Current Liabilities

A quick ratio above 1 is good and shows the company has enough liquidity to fulfill its short-term obligations. Ideally, you want it above 1.5. With a ratio below 1, the company has to be quick in selling its inventory. If it doesn’t sell it off fast enough, it’ll have to dig into its line of credit.

Cash Ratio

The cash ratio is straight-forward but restrictive. It shows if the company has enough cash on hand to cover short-term liabilities. However, it focuses too much on cash, ignoring other assets that can help bad situations. In challenging times, you don’t only count what’s inside your wallet. You look to other resources you can use, assets you can sell, or people you can call to raise cash. The same applies to a business.

Cash and Short-Term Equivalents / Current Liabilities

A ratio below 1 shows potential short-term liquidity problems. If this happens, look at other ratios to understand where the money will come from in the coming months. If you can’t find more cash flow, the company might have to rely on debt to keep going.

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Leverage or Solvency Ratios

Leverage ratios are also called Solvency ratios. When you look at leverage ratios, it’s hard to tell what’s good or bad because leverage can end up good or bad. I borrowed money to create DSR. Today, we can probably agree it was a good decision; had I failed however, it would have been a bad decision, leaving me with an empty website and debt.

Leverage ratios show how the company structured its long-term debt. Is it a good or bad choice? It depends on each situation and industry. I find leverage ratios useful to understand in which context a company will have financial problems.

Debt Ratio or Debt to Assets Ratio

Dividing a company’s long-term debt by its total assets indicates the strength of its balance sheet, and whether the company has gone into too much debt compared to the assets it has.

(Long Term Debt + Current Portion of Long-Term Debt) / Total Assets

A ratio above 1 tells you the company has a lot of debt and few assets to show for it. A debt to assets ratio below 1 is preferable. A zero-debt ratio means the company is debt-free!

Debt to Equity Ratio

I like the debt-to-equity ratio; it tells the story of whether a company uses leverage or not to finance its projects. Some companies prefer to use equities and have a lower debt to equity ratio, while others prefer the leverage offered by debt.

Total Liabilities / Total shareholders equity

There’s no perfect ratio here. Compare a company’s ratio to its industry and put it in context. A high debt to equity ratio often points to a company that’s been aggressive in financing growth with debt, and often results in volatile earnings. A lower ratio means lower risk as debt holders have fewer claims on the company’s assets.

Financial Debt to EBITDA

This ratio compares the financial debt to earnings before interest, taxes, depreciation, and amortization (EBITDA). Financial debt is what the firm owes that isn’t related to day-to-day operations. It shows the relation between the company’s debt and its profit.

Financial Debt / EBITDA

A ratio above 1 is normal. After all, you don’t expect a business to pay back its debt with its profit in a single year. However, you do expect it to use its profit to reimburse the bank at some point. The higher the ratio, the higher the potential for a solvency issue.

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What’s Good? What’s Bad?

Do not look at debt ratios in isolation. A high debt ratio could mean the company is going into very promising projects such as acquisitions, or that it borrowed too much and is facing financial difficulties. I compare debt ratios for a few companies in the same industry and add context to explain them. I believe it’s more important to understand how a company is structured than only looking at the numbers.

Sustained high debt levels make it difficult to maintain a dividend growth policy. If you don’t find growth across the dividend triangle, chances are debt will become a burden. My focus remains on finding companies with robust balance sheets who can i

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