How to Analyze A Company’s Debt

How to Analyze A Company's Debt

Debt is the amount owed to individuals or organizations by a company for funds borrowed. There are two types of debt: current debt and non-current debt. Current debt is repaid within one year. Non-current debt is repaid over multiple years. The subject of debt is extensive and only an overview of the topic will be discussed.

By analyzing the balance sheet, debt ratios help investors determine a company’s financial strength. A strong balance sheet enables a company to capitalize on business opportunities, as well as ensures adequate assets and cash are available in economic downturns.

A strong balance sheet can also be used to acquire debt for corporate expansions and other initiatives. If management effectively allocates capital and increases income by more than the interest expense, a company’s profits are enhanced from borrowing. A company without debt may limit its potential.

There are five key debt ratios that help investors determine a company’s financial strength. They include: current ratio, debt-equity ratio, debt-equity ratio – modified, interest coverage ratio and quick ratio. To illustrate the application of these debt ratios, figures from Tempur-Pedic International (TPX) will be used.

Current Ratio
The current ratio is a company’s current assets divided by current debt. Investors use the current ratio to determine a company’s short-term financial strength. A current ratio of one or greater means a company can satisfy its current debt. The higher the current ratio, the more liquid a company. A current ratio of less than one means a company cannot satisfy its current debt without additional funds. To illustrate: In Q1/2008, TPX’s current assets ($340,190,000) divided by current debt ($123,060,000) was 2.8 (industry average was 2.2). For every dollar of current debt, TPX had approximately three dollars of current assets to satisfy it.

Debt-Equity Ratio
The debt-equity ratio is a company’s total debt divided by shareholder’s equity. Preferred stocks are often added to the company’s total debt. Investors use the debt-equity ratio to determine the amount of financial leverage used by a company. A debt-equity ratio of one or greater means the majority of a company’s assets have been acquired through debt. The higher the debt-equity ratio, the less liquid a company. A debt-equity ratio of less than one means the majority of a company’s assets have been acquired through equity (if a company was liquidated, shareholder’s equity could satisfy total debt).

In Q1/2008, TPX’s total debt ($597,070,000) divided by shareholder’s equity ($70,240,000) was 8.5 (industry average was 1.2). If TPX was liquidated, shareholder’s equity could not have satisfied total debt. TPX’s debt-equity ratio was also higher than the industry average. However, between Q4/2007 and Q1/2008, TPX’s total debt decreased from $602,040,000 to $597,070,000. Shareholder’s equity also increased from $48,140,000 to $70,240,000. In addition, over the last six years, TPX’s management averaged a 75% return on equity, which demonstrated effective capital allocation. If TPX’s average interest rate was 10%, the incremental profit from borrowing was 65%.

Debt-Equity Ratio – Modified
Investors also use a modified version of the debt-equity ratio. The modified version of the debt-equity ratio is a company’s non-current debt (versus total debt) divided by shareholder’s equity.  In Q1/2008, TPX’s non-current debt ($596,790,000) divided by shareholder’s equity ($70,240,000) was 8.5 (industry average was 1.2). 

Interest Coverage Ratio
The interest coverage ratio (ICR) is a company’s operating income divided by interest expense. Investors use it to determine a company’s ability to pay the interest expense on its total debt. An ICR of one or greater means a company can satisfy its interest expense. The higher the ICR, the more liquid a company. An ICR of less than one means a company cannot satisfy its interest expense.  In Q1/2008, TPX’s operating income ($29,330,000) divided by interest expense ($7,690,000) was 3.8 (industry average was 5.5). While TPX’s ICR was less than the industry average, the company had approximately four dollars of operating income for every dollar of interest expense.

Quick Ratio
The quick ratio is a company’s current assets less inventories divided by current debt. It is used to determine a company’s ability to meet its current debt with its most liquid assets (inventories are excluded). A quick ratio of one or greater means a company can meet its current debt. The higher the quick ratio, the more liquid a company. A quick ratio of less than one means a company cannot satisfy its current debt without additional funds.  In Q1/2008, TPX’s current assets ($340,190,000) less inventories ($112,000,000) divided by current debt ($123,060,000) was 1.9 (industry average was 1.2). TPX had two dollars of quick assets for every dollar of current debt.

In addition to debt, several other factors should be analyzed by an investor before a business or equity is purchased. These factors include: book value, durable competitive advantage, intrinsic value, management, net margin, return on equity, etc. These factors will be the subject of future articles.

All contents copyright © 2008, Josh Lowry.  All rights reserved.

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