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Measuring Indebtedness of Your Investment

February 06, 2012 | About:
Chandan Dubey

Chandan Dubey

97 followers
This is a million dollar question. How does one actually answer this question? How do we see if one of the companies we are planning to invest in or one of our holdings is going to go bankrupt? I am grappling with this question for a while now. How does one actually find a “safe” investment? In this article, I plan to touch on this question and give some pointers on how to do this. The readers are most welcome to add something of their own because I do not have a well-rounded answer. Hopefully, there will be a discussion and we will come up with something.

1. Debt to equity ratio

This is one of the most used ratios. Let us first define this. Debt here is the total liabilities from the balance sheet and equity is the contribution of the share holders and the minority interest towards the company’s asset. This is a measurement of how much the debtors have committed to the company versus how much the shareholders have committed.

Landmine 1: The goodwill and the intangibles on the balance sheet reduce the equity. Companies making overpriced acquisitions might end up with a lot of goodwill and intangibles and sometimes negative equity.

Landmine 2: Stock repurchases reduce the equity. So, even though the company has a sound financial position like Philip Morris (PM) it may have a bad debt-to-equity ratio (currently greater than six, see here for a discussion). Also, see Kellog’s (K) for example.

Landmine 3: It includes operational debt, i.e., the short term debt, accounts payable, taxes payable etc. This is not actually debt per-se because during the operations the company will pay them using the receivables and cash from operations.

For the long term investor who wants to be safe the debt-to-equity ratio is a pretty good measurement. If the equity is quite high compared to the liabilities then barring the landmines, the company is safe in most cases. But as we will see, this ratio falls far short of figuring out if a company will go bankrupt.

2. Interest coverage ratio

This ratio is a measure of how easily a company will be able to meet its interest expenses on the outstanding debt. The ratio is calculated by dividing a company’s EBIT (earnings before income taxes) by the interest expense for the same period. The EBIT can be found in the income statement and the interest expense from the cash flow statement of the company. The EBIT is used because the interest is paid prior to the tax. The lower the ratio, the more the company is burdened by its debt. This does not necessarily measure the debt per se. The company also needs to pay the current part of the outstanding debt it has and hence the interest does not tell the full story. But as a rule of thumb an interest coverage ratio of less than 2 is quite unsafe as a long-term investment.

A company has to pay the interests on the debt it has. The non-payment of the debt principle is a serious negative for a company, but it may survive for a while as long as it can service the interest on the debt. A cost-benefit analysis must be done to make sure that additional offering of the debt to finance the assets is a good idea for the company or not as the interest expense is tax deductible and can do wonders for the shareholder returns.

3. Comparing debt to cash flow

This is the most uncommon measurement. I found this out because I was actively looking for a way to measure debt in terms of earnings. In my opinion, this makes the most sense.

The ratio is operating cash flow (OCF) divided by the total debt of the company. The total debt can be defined as the sum of long term debt, short term borrowings and the current portion of the long term debt. This ratio measures a company’s ability to cover its debt with the yearly cash flow from its operations. If we want to be more conservative we can use the free cash flow (FCF) which is operating cash flow — capital expenditure (OCF — CapEx) instead of OCF.

Obviously, a high percentage ratio is indicative of a company which can cover its debt covenants using its cash flow generation ability while a low percentage will indicate too much debt or weak cash flow generation. It is advisable however to investigate the reasons behind the ratio. To do this, one should look at the historical developments in this ratio which will spot warning signs.

Bottom line

Now, which one is the best ratio to describe the indebtedness of a company? This is probably the wrong question. Each one measures something else and alone they don’t paint the whole picture.

If one wants to be safe, a good rule of thumb is good interest coverage, a safe debt-to-equity ratio and a high debt-coverage ratio (using the FCF or OCF). Make sure that you do understand the numbers involved in these ratios. A "safe" investment may have large debt-to-equity ratio (PM, K). During a bad year or recessions, a company may have collapsing earnings and cash flow and hence low interest coverage and low debt coverage ratio. In this case a history of these ratios gives a better picture and can spot warning signs.

About the author:

Chandan Dubey
I invest because I want to be free by the time I reach 40 years of age i.e., 2025. My investment style is to find a small number of bets with large margins of safety. I pay a lot of attention to management and their incentive. Ideally, I like to buy owner operator businesses. I am fortunate to have a strong inclination towards studying. I aid my financial understanding by extensive reading in psychology, economic, social sciences etc.

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