When you invest in a company, you need to look at many different financial records to see if it is a worthwhile investment. But what does it mean to you if, after doing all your research, you invest in a company and then it decides to borrow money? Here we look at how you can evaluate whether the debt will affect your investment.
How Do Companies Borrow Money?
Before we can begin, we need to discuss the different types of debt that a company can take on. A company can borrow money by two main methods:
- By issuing fixed-income (debt) securities - like bonds, notes, bills and corporate papers; or
- By taking out a loan at a bank or lending institution.
- Fixed-Income Securities
Debt securities issued by the company are purchased by investors. When you buy any type of fixed-income security, you are in essence lending money to a business or government. When issuing these securities, the company must pay underwriting fees. However, debt securities allow the company to raise more money and to borrow for longer durations than loans typically allow.
Borrowing from a private entity means going to a bank for a loan or a line of credit. Companies will commonly have open lines of credit from which they may draw to meet their cash requirements of day-to-day activities. The loan a company borrows from an institution may be used to pay the company payrolls, buy inventories and new equipment, or keep as a safety net. For the most part, loans require repayment in a shorter time period than most fixed-income securities.
What to Look for
An investor should look for a few obvious things when deciding whether to continue his or her investment in a company that is taking on new debt. Here are some questions to ask yourself:
How much debt does the company currently have?
If a company has absolutely no debt, then taking on some debt may be beneficial because it can give the company more opportunity to reinvest resources into its operations. However, if the company in question already has a substantial debt amount, you might want to think twice. Generally, too much debt is a bad thing for companies and shareholders because it inhibits a company's ability to create a cash surplus. Furthermore, high debt levels may negatively affect common stockholders, who are last in line for claiming payback from a company that becomes insolvent.
What kind of debt is the company taking on?
Loans and fixed-income securities that a company issues differ dramatically in their maturity dates. Some loans must be repaid within a few days of issue, while others don't need to be paid for several years. Typically, debt securities issued to the public (investors) will have longer maturities than the loans offered by private institutions (banks). Large short-term loans may be harder for companies to repay, but long-term fixed-income securities with high interest rates may not be easier on the company. Try to determine if the length and interest rate of the debt is suitable for financing the project that the company wishes to undertake.
What is the debt for?
Is the debt a company is taking on meant to repay or refinance old debts, or is it for new projects that have the potential to increase revenues? Typically, you should think twice before purchasing stock in companies that have repeatedly refinanced their existing debt, which indicates an inability to meet financial obligations. A company that must consistently refinance may be doing so because it is spending more than it is making (expenses are exceeding revenues), which obviously is bad for investors. One thing to note, however, is that it is a good idea for companies to refinance their debt to lower their interest rates. However, this type of refinancing, which aims to reduce the debt burden, shouldn't affect the debt load and isn't considered new debt.
Can the company afford the debt?
Most companies will be sure of their ideas before committing money to them; however, not all companies succeed in making the ideas work. It is important that you determine whether the company can still make its payments if it gets into trouble or its projects fail. You should look to see if the company's cash flows are sufficient to meet its debt obligations. And make sure the company has diversified its prospects.
Are there any special provisions that may force immediate payback?
When looking at a company's debt, look to see if any loan provisions may be detrimental to the company if the provision is enacted. For example, some banks require minimum financial ratio levels, so if any of the company's stated ratios drop below a predetermined level, the bank has the right to call (or demand repayment of) the loan. Being forced to repay the loan unexpectedly can magnify any problem within the company and sometimes even force it into a liquidation state.
How does the company's new debt compare to its industry?
Many different fundamental analysis ratios can help you along the way. The following ratios are a good way to compare companies within the same industry:
- Quick Ratio (Acid Test) - This ratio tells investors approximately how capable the company is of paying off all its short-term debt without having to sell any inventory.
- Current Ratio - This ratio indicates the amount of short-term assets versus short-term liabilities. The greater the short-term assets compared to liabilities, the better off the company is in paying off its short-term debts.
- Debt-to-Equity Ratio - This measures a company's financial leverage calculated by dividing long-term debt by shareholders' equity. It indicates what proportions of equity and debt the company is using to finance its assets.
The Bottom Line
A company increasing its debt load should have a plan for repaying it. When you have to evaluate a company's debt, try to ensure that the company knows how the debt affects investors, how the debt will be repaid and how long it will take to do so.