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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 take a 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. There are two main methods by which a company can borrow money: (1) by issuing fixed-income (debt) securities - like bonds, notes, bills and corporate papers - and (2) by taking out a loan at a bank or lending institution.
- Fixed-Income Securities - Debt securities issued by the company are purchased by investors, so, 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.
- Loans - 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 in order to meet their cash requirements of day-to-day activities. The loan a company borrows from an institution may be used to pay for the company payrolls, buy inventories and new equipment, or to 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
There are a few obvious things that an investor should look for when deciding to continue his or her investment in a company that is taking on more new debt. Here are some questions you can ask yourself:
How much debt already exists?
If a company has absolutely no debt, then taking on some debt may be beneficial since it offers the company more opportunity to reinvest resources into its operations. However, if the company in question already has a substantial amount of debt, you might want to think twice. Generally, too much debt is a bad thing for companies and shareholders because it inhibits the company's ability to create a surplus in cash, which requires more earnings. 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 trying to take on?
Loans and fixed-income security that the 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 a 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 necessarily 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 it meant to repay or refinance old debts for which the company cannot maintain its payments, or is it for new projects that has the potential to increase revenues? Typically, you should think twice before purchasing a stock in companies that have repeatedly refinanced their existing debt, which indicates that the company is unable to meet its obligations and may be in financial trouble. 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. This type of refinancing, which aims to reduce the debt burden, however, 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 you determine whether the company can still make its payments if it gets into trouble or if its projects fail. You should look to see if the company's cash flows are sufficient enough to meet its debt obligations. And do make sure the company has diversified its prospects, by avoiding putting all its eggs into one basket.
Are there any special provisions that may force immediate pay back?
When looking at a company's debt, look to see if there are any loan provisions that may significantly detriment the company if the provision is enacted. For example, some banks require minimum financial ratio levels, so if any of the stated ratios of the company drop below a predetermined level, the bank has the right immediately 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 its new debt compare to its industry?
There are many different fundamental analysis ratios that may 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 of its short-term debt without having to sell any inventory.
- Current Ratio - This ratio indicates how much coverage short-term assets have over short-term liabilities. The greater the coverage, 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 shareholder's equity. It indicates what proportions of equity and debt the company is using to finance its assets.
Conclusion
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.
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by Investopedia Staff, (Contact Author | Biography)
Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including more than 1,200 original and objective articles and tutorials on a wide variety of financial topics.
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