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:

  1. By issuing fixed-income (debt) securities - like bonds, notes, bills and corporate papers; or
  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. 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 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.

Related Articles
  1. Economics

    What The National Debt Means To You

    The U.S. deficit seems to grow every year. But how does it actually affect you?
  2. Credit & Loans

    How Countries Deal With Debt

    For many emerging economies, issuing sovereign debt is the only way to raise funds, but things can go sour quickly.
  3. Investing Basics

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  4. Economics

    Debt Monetization: A Nearsighted Government Policy?

    We look at whether this financial practice benefits a government in the long term.
  5. Bonds & Fixed Income

    A Look At National Debt And Government Bonds

    Learn the functions of the U.S. Treasury, and find out how and why it issues debt.
  6. Stock Analysis

    These S&P 500 Companies Hold the Most Cash

    Large cash positions allow for many different options and here's why they are beneficial to shareholders.
  7. Economics

    How Does a Credit Facility Work?

    A credit facility is a loan or collection of loans a business or corporation takes to generate capital over an extended period of time.
  8. Professionals

    Worried About Bond Market Liquidity? Try ETFs

    If you're looking for liquidity in the bond market, then turn to bond ETFs. Here is an analysis of 11 to consider.
  9. Fundamental Analysis

    Calculating the Net Debt to EBITDA Ratio

    Financial analysts typically use the net debt to EBITDA ratio to determine a company’s ability to pay its debt.
  10. Fundamental Analysis

    Financial Analysis: Solvency Vs. Liquidity Ratios

    Solvency and liquidity are equally important for a company's financial health. A number of financial ratios are used to measure a company’s liquidity and solvency, and an investor should use ...
  1. What are the most common leverage ratios for evaluating a company?

    One of the most important steps in evaluating any given firm, for both investors and lenders, is to analyze debt obligations. ... Read Full Answer >>
  2. Which leverage ratios are most useful for analyzing manufacturing companies?

    The use of leverage (debt) is common among businesses in the manufacturing sector, that borrow to begin or expand operations. ... Read Full Answer >>
  3. How does a company obtain a bank guarantee?

    A bank guarantee serves as a promise from a commercial bank that the liability of a particular debtor will be met if contractual ... Read Full Answer >>
  4. How accurate or important is the debt service coverage ratio (DSCR) in evaluating ...

    Both creditors and investors use the debt service coverage ratio, or DSCR, when analyzing the financial condition of a company. ... Read Full Answer >>
  5. What is the difference between the debt ratio of a company and the debt ratio of ...

    The difference between the debt ratio of a company and the debt ratio of an individual is primarily one of scale and complexity. ... Read Full Answer >>
  6. What's the difference between a credit bureau and a credit rating agency?

    Individual consumers and corporations both carry credit scores and credit history reports that illustrate to lenders how ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!