Key Concept: Corporate Debt
Corporate debt can be a dangerous red flag or a desirable asset. Here are some tips to help you determine the difference.
Debt is a central part of any company’s balance sheet. It can make or break an investment thesis. At the same time, almost any company carries some debt. Is debt always a danger, or is there any good debt? How can you tell when corporate debt is a problem?
Does Debt Matter?
The answer to this question is simply “yes.” Debt is the single most common reason why companies go bankrupt. Since bankruptcy usually means a total loss for the investors, it matters a lot. Debt is also often a hidden risk. Just looking at superficial metrics can make an investor miss a mounting debt problem.
But debt is not purely negative. It is also a multiplier of force for great companies. It can extend the company’s equity further, increasing profitability, growth, and returns to shareholders.
Debt allows companies to make acquisitions and expand their businesses without issuing new shares, which would dilute the value of their existing shares. If the borrowed money is profitably invested, the interest rates are reasonable, and the company has the capacity to service the debt, this can be a good thing.
Debt has an immediate bearing on a company’s value – understanding a company’s liabilities is as important as understanding its assets – and understanding a company’s debt standing is a key part of value investing.
How Corporate Debt Works
Corporate debt works differently from individual debt. Corporations typically borrow by issuing bonds. They then make regular interest payments and repay the principal in full on a set date.
Most of the time, corporate debt is “rolled over,” meaning a new bond is used to reimburse the old one. Knowing the repayment schedule of a company is crucial to understanding its debt.
This also means that debt payments might not show up in current profit and loss statements, but will still affect future profits. If the debt cannot be rolled over, this can spell real trouble for the company.
Debt also makes a company very sensitive to rising interest rates. If the rolled-over new debt is at a higher interest rate, its interest cost will rise up significantly, bitting into profit margins.
One last thing to know is what happens in a bankruptcy. Bondholders are the first ones to be paid with the money that’s left (after employees and suppliers). So shareholders will see any money only if anything is left after repaying the bonds. This is why high debt leading to bankruptcy tends to wipe out shareholders.
When is Debt Bad?
There are several factors that should raise a red flag over debt.
Quantity: too much debt relative to the company’s earnings is a bad thing.
Quality: look at how the company is spending its borrowed money. Pouring borrowed money into purely considered acquisitions or unsustainable expansion is a bad sign.
Interest rates: if a company is paying above-average interest rates, there’s a good chance that bond rating services see an elevated risk of default there.
Overall, to stay perfectly safe, the total debt load should be small enough that free cash flow could cover it. So in case of business slow down, or debt cannot be rolled over on favorable terms, the company is not in danger.
Corporate debt is also more dangerous for cyclical or less reliable businesses. On the opposite side, very predictable businesses, for example, utilities, can stomach a relatively high level of debt before being at risk.
A few metrics can be used to measure debt. For Example:
Interest coverage: This is the number of times the company can cover the interest on its debt with its profits, specifically Earnings Before Interest and Taxes (EBIT). The higher, the better. Anything below 1 makes it a so-called “zombie company,” able to survive only by constantly taking on more debt.
Debt ratio: This is calculated by dividing total liabilities (long-term debt, but also invoices and salaries to pay, etc…) by total assets. This tells you if the company owes more money than its assets are worth.
Debt to free cash flow: this can be calculated with total debt or interest. This is a good metric because debt needs to be paid with actual cash. Even more than interest coverage, this will give a good view of how large and expensive the debt is compared to cash flow.
Cash – current liabilities: This is to be analyzed in parallel with the debt schedule. If the company has enough cash on hand to pay its liabilities in a year, and then some years of long-term debt/bond repayment, the situation will be a lot safer.
If a company’s cash on hand exceeds its debt, the company is effectively debt-free.
Debt Red Flags
Beyond the purely quantitative metrics, a few elements should be raising alarm bells:
Paying dividends with borrowed money, and the debt is used to keep the dividends up. This means the company is gambling its future for short-term support of the stock. Doing this long enough is the road to bankruptcy.
Debt is rising, but profitability is not. This means the borrowed money is not being used productively or that the company has a serious profitability problem.
The company has much more debt than its competitors. That suggests that during a downturn, it will be the first one to go down or have to sell assets.
Debt is used for expensive M&A (merger and acquisition). These deals are done, more often than not, to help grow revenues and the salary of management. Most M&A fail to deliver the promised returns, especially if the purchase price was high.
Debt is used to re-purchase shares, even if the shares are currently pricey. Good capital allocation is a crucial part of good management. Buying expensive shares just to reach stock price goals that will boost management bonuses is a bad idea.
These signals are not grounds for automatic rejection. They are an indication that you need to take a much closer look to determine whether the company’s debt is sustainable.
When is Debt Good?
At this point, it might look like debt is only a risk and a bad idea. That is not always the case. Debt can be a great tool to increase a company’s profitability.
For example, if a company raises $1B to build a new facility, and this facility produces $500M in free cash flow, this is a great investment with a stunning 50% Return on Invested Capital (ROIC). The alternatives would have been negative for the shareholders:
Reduce dividends to “save” up to $1b, which may also hurt the stock price in the short term.
Postpone or cancel the investment, missing the business opportunity and slowing down growth.
Issue new shares to raise $1B of equity, diluting existing shareholders.
Obviously, shareholders should not count only on corporate debt to protect growth and their dividends. But at the same, not using any debt is going to reduce the Return On Equity (ROE) and likely hurt the profits of existing shareholders.
So the question is not so much if debt is bad, but how much is okay and how much is too much?
Here is when debt is good (or at least okay):
Profitability and margins are high and/or rising. More investments will probably pay off.
Debt is used to purchase valuable assets at a good price. Taking some debt to seize a bargain is a good use of debt.
Underlying organic growth (revenues, earnings, cash flow) is stronger than debt load growth. This is just a sign the company is growing and not excessively diluting its shareholders.
Debt has a distant repayment schedule and a low-interest rate. If the debt has interest below 2%-3% and repayment is far in the future, inflation alone might be enough to help reimburse it.
The company is a monopoly and/or has strong pricing power. Quality companies can take more debt because their business model is stronger.
One last comment is that debt is more or less dangerous depending on the point in the business cycle you’re in.
At the bottom of a recession, debt can be used to buy competitors on the cheap, seize market share and prepare for the future. Raising money when no one else can is powerful.
On the opposite, debt on top of a growth period can be dangerous. The profits and expected growth might never materialize. Cash flow might shrink. The cheap credit might dry out without warning, and it might not be possible to roll over bonds. So when profits are at their highest, paying off debt and reducing leverage is probably wiser and a sign of good management.
Debt is often treated by investors in a binary way: they either do not pay attention to it or treat it as a boogeyman.
Both are incorrect.
Debt is much more like fire or a blade. It’s a very useful and powerful tool if properly used. It’s dangerous if used improperly.
Debt should be the central focus of a balance sheet analysis, and it should be high on the checklist of risks. It should also be viewed as a way for quality management to power charge growth, returns to shareholders, and profitability.
Could You Share This Post?
Not only will you help your friends become better investors but recommendations are the lifeblood of Stock Spotlight’s growth. A few people sharing it on Twitter can really be a huge deal in terms of driving audience growth.
This article originally appeared on FinMasters.com: Key Concept: Corporate Debt