If companies cannot afford to pay their debt then eventually they will go bankrupt and you, the shareholder, will be left with NOTHING! How much debt a company has and more importantly if they are able to pay back their debt is essential to know before investing in the company. Ultimately companies who become too over-leveraged with debt may face trouble repaying it if their revenue declines, their earnings drop, if interest rates rise or in the case of COVID-19, an unexpected black swan event comes out of nowhere. Below is the checklist I use when analyzing the debt of a company.
Debt Analysis Checklist:
Step 1: Calculate Total Debt
- Remember use only "Term Debt" both short term and long term
- Liabilities are NOT Debt
- Ideally total debt would be decreasing over time, however, more important than the total dollar amount is whether or not the company can pay it
Step 2: Calculate Debt to Equity
- Debt / Equity = Long Term debt / Shareholder equity
- I do not include Short Term debt in the above equation unless the company does not have enough cash/cash equivalents and short term investments to cover it
- Ideally companies would have 25% or less debt
Step 3: Does the company have positive free cash-flow?
- We want to see positive free cash flow. This means the company is actually bringing in "cash" which it could use to pay back debt
- If a company has negative free cash flow then it's not bringing in any money!!! How can they pay their debt obligations with no money?
Step 4: Does the company have enough cash/cash equivalents/short term investments to cover short term debt?
- We want to see companies have enough cash/equivalents and short-term investments on their balance sheet to cover short term debt
Step 4: Does the company have enough free cash flow to cover short term debt?
- If the company is free cash flow positive, does that amount meet or exceed its short term debt obligations. Ideally it would.
Step 5: Check the income statement to see how much the company's interest expense is.
- Does interest / dividend income cover interest expense? This would be ideal!
- Does operating income / EBIT cover interest expense? If so what is the TIE ratio (times-interest-earned ratio: EBIT / Interest Expense). The higher the number the better!
Step 6: Look for trends in net income and free cash flow
- We want to invest in companies that make money and have positive free cash flow. If these numbers begin to go negative then investigate and determine if the company can turn things around.
Step 7: Calculate the company's overall cash position
- Overall cash position = cash + equivalents + short term investments / Long-Term Debt
- Higher the number the better.
Step 8: Remember not all debt is bad. What is more important that the total amount of debt is whether the company has the operating income, interest/dividend income, or free cash flow to cover it. Even if they took a significant hit to revenue - would the company still be able to pay its debt obligations - those are the types of companies we want to invest in!
Submitted July 26, 2020 at 08:41PM by JWM937 https://ift.tt/39vnAhn
