Some companies can grow without taking short or long term debts. However, the truth is many companies can not prosper without taking debts. There are bad debts and unnecessary debts taken by companies that become a liability if they can not be paid. To what degree the company debt makes the business unattractive to value investors?
Although companies that do not have debt or little debt are a huge sign, they will not go bankrupt. It is almost impossible for many companies not to take debts as it is crucial to their development. Therefore, the investor should analyse why the business is taking the debt to better judge the company’s position before buying or selling a stock.
How to analyse the company debt position?
In general, there are a few steps the investor must do to analyse the company debt position:
1- Calculate the asset to liability ratio
A company should have more assets than liabilities. For a company to have a good position, the ratio should be above 1.5, where a ratio of 2 indicates that the assets are twice the liability. To calculate this ratio, divide the current assets by the current liability found in the company income statement.
2- Calculate the debt to equity ratio
Preferably a company should have less than 1 of debt to equity ratio. To calculate this ratio divide the total company debt by the company equity found in the company income statement.
3- Reviewing the company historical debt
Knowing the ratios above is not sufficient because a company could take more debt in one year that is significantly higher than the previous years resulting in high debt ratios or a low debt ratio if the company has taken no debt that year. Therefore, the investor should look at the company’s history to see the debt average at least for the past 5 years and make reasonable adjustments if required.
4- The debt type
The savvy investor should go further by looking into the reason for taking debt and make conservative assumptions about the company’s ability to pay that debt in the future. Some companies need debt for operation costs, others for new business ventures and others to pay dividends to shareholders. Therefore, the investor should study the reasons for taking debt to understand better the management and how they choose to operate the business.
What are the debts types companies take?
Companies take different types of debts. Some can be beneficial to the shareholders for expansion and development of the business, and some can put the business in an unfavourable position. The value investor must conduct a thorough analysis of why the company is taking the debt to make an informed decision. The following are the most common reasons why companies borrow money:
1- Taking debts for operations purposes
The companies need to take some debts to pay their employees or purchase the raw materials required for their operations. This type of debt depends mainly on the company’s current cash flow (Cash left after operations, tax, dividend.. etc.). Companies with poor cash flow need to take debt to produce and manufacture the goods to bring revenue.
Every organisation’s goal is to increase sales of its goods and services which means that poor cash flow companies can increase the amount of debt taken every year.
On the other hand, poor cash flow means that the company are at high risk of going bankrupt, especially for companies that need to spend more money every year to ramp up production or launch new products. Any minor issues or extra costs can put the company at a considerable disadvantage financially and face bankruptcy if it can not pay back its debts.
2- Taking debts for expansion or new business venture
This means that the company aims to spend more money than it has or is comfortable paying for, so it takes debts to cover the extra expenses. A new business venture is a sign of expansion where the company is exploring new markets or new ways to attract paying customers.
Some expansions are costly, others are cheap, which mainly depends on the industry. R&D plays a huge factor in new business ventures; that can be risky if the capital required is high as some ventures will not come to fruition until a new product is produced and customers are willing to pay for it.
Management and venture size play are also significant in new business ventures. Management determines the capital allocated and the size of the venture. Some management can be quite bullish on new markets that give huge capital and resources to it and deviate from the core businesses, which is usually unfavourable by investors as it increases the business uncertainties.
The investor should ask why go to a new business venture if you do not have the capital for it? Some ventures can be the next evolutionary steps for the business. Others are just trial and error where the business allocates small resources to some ventures until they can bring the proof of concept. The companies that allocate too many resources to one venture are extremely risky if we can not reasonably predict the outcome.
3- Taking debts for production increase to meet consumer demand
Companies that can not meet consumer demand need to increase production to meet that demand. Ramping production can increase the company revenue, but it does necessarily increase profit as companies can spend huge capital and take debt to meet the demand.
This type of debt depends on the management, the market demand and the capital required to increase production. The management must understand the reasons for the increase in consumer demand.
Some demand can be short-term, such as more demand on electric cars because of increasing fuel prices, but will the fuel prices stay high forever? On the other hand, the increase in demand might be permanent, such as unique products that other companies cannot replicate, giving the company a huge advantage and more confidence that the demand is long-term.
The capital required to increase such production needs to be thoroughly studied. If you are a car company and all your factories are operating at maximum capacity, then the only way to increase production is to open new factories, which can be costly. While if you are an internet provider, the only way to increase sales is by increasing coverage through building towers which is less expensive than building new factories.
Understanding the market demand is essential; you do not want to allocate huge capital and take on huge debt if you know that the demand is temporary due to short term demand. Therefore, investors should look beyond the company’s recent profit and debt and understand the market economics to make a more informed decision.
4- Taking debts to pay dividends to shareholders
This type of debt is quite common. Many companies would rather pay dividends to shareholders than invest back into the business. Many established companies that can not find new ways to expand pay dividends to attract and keep shareholders.
However, once a company starts losing market share to other companies, they start taking loans to pay their shareholders instead of cutting dividends or stopping dividends as doing so can bring the stock down. Such a thing can deceive investors into staying invested in the company.
The intelligent investor should dive more deeply into the company’s financial position. Although the dividends might be high, there is no guarantee that the investor will get back the initial invested capital.
5- Taking debts to pay old debts
Taking debts to pay old debts is where companies get extremely desperate and almost at the edge of bankruptcy. Taking new debts to settle an old debt is just trying to delay the inevitable as the company still has to pay the debts. This can be even worse when the new loan can have higher interest rates than the previous ones—or accepting extension for current debts for higher interest rates.
Many companies take too many debts in the name of expansion or developing new products and gamble huge capital on one thing that may be a total failure. Once that speculation proves to be a failure, the company is left with a huge debt to repay, so it either sells current assets to pay some of the debts or takes more debts to pay the old debt. Sometimes, the company can not find any lenders due to its current financial position, so it sells its assets or declares bankruptcy.
If the current assets are what brings profit, then the company has lost all competitive advantage. Therefore, taking more debts can give the company some time to pay the debts through company profit. However, such a business can stay in debt for a very long time and hinder it from borrowing more money or developing as a business. Therefore, such investments are not usually favourable to value investors.
6- Taking debts to renovate
Taking debts to upgrade offices, stores or equipment that does not necessarily bring direct profit to the business is usually not a good way of spending money. It can be acceptable if the renovation can be done out of the company’s pocket or by borrowing small capital or short-term debts.
However, if the company decides to take huge debts for some renovation that may not bring profit or there is huge speculation in that area, this debt is not usually favourable. So what qualifies as a renovation? It’s simply anything that has nothing to do with the core business done at the management leisure. Then it is a bad way of spending money.
Although those types of spending can significantly impact staff productivity, it is not favourable if it is done extensively through debt. The investor should pick a company with management that knows how to invest profit effectively back into the business, and renovating will not guarantee a payback to the shareholders.
7- Taking debts to buy new equipment
This type of debt is different from renovation, where the management takes debt to buy equipment that can bring direct profit to the business. For example, if a company needs to spend $10 million but knows it will get 10 times that amount back, this type of spending is highly favourable.
If a microchip company need to take debt to buy new equipment to double the speed of its processors, then this is good debt. However, the signs are not usually that clear, and it is up to the investor to take a conservative analysis.
The management might be bullish on equipment upgrades to bring more profit. However, investors will not see this profit any time soon, which is why understanding the business and the product can help the investor make good decisions as every company has a different story.
The Bottom Line
The investor needs to analyse the company’s debt by looking at its history and the reason for taking the debt. Some debts are considered beneficial, and others risky. It is up to the investor to navigate those types of debts and make a conservative analysis.
If the investor approaches stock investing like successful value investors such as Warren Buffett by understanding the meaning, management, and competitive business advantage, then distinguishing between good debt and bad debt is much easier for the investor.
To learn about this style, you can read: The Buffett-Munger Style Of Investing
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