Analysing Debt When Investing in Stocks

Many investors either gloss over, or do nothing when it comes to analysing debt levels in stocks. Some even consider more debt to be a necessarily a good thing. In this article we will dispel some myths and give you some practical tools to help you conduct your own analysis of debt in common stocks.

Two Schools of Thought

There are perhaps two schools of thought here. First, there are those who think high debt is a good thing, because it shows a company is growing- it is using more capital. Second, there are those who think little or no debt is a good thing, because it shows a company is using its retained earnings to grow.

Like most things in life, it is never one or the other. Life and the markets are always more complex. The devil is in the detail, yet let me try to simplify things and give you some tools you can easily use.

The common ground of these two schools is growth. So, the key question is where the company is growing sustainably over time. How it grows, how it sources capital, either through retained earnings or external debt requires more analysis.

Preferred Approach

The preferred approach I will argue is, it is better for a company to grow through retained earnings first and foremost. However, external debt may sometimes be needed, for instance when a company wants to launch a new product or break into a new market or region. When this occurs, the question then is how well is the company managing its debt,? How quickly it can minimise it, and then return to natural growth via retained earnings?

Debt Management

Responsible debt management is a key area to examine. If management is too loose with debt, then debt can, and will come back to haunt them. It will forever be like a noose around the company’s neck if debt is left unchecked. This will stifle future growth and this will negatively impact on the stock price. Remember, if a company cannot service debt effectively, and constantly requires more debt to grow, then these are not healthy signs.

Key Metrics

There are several metrics investors should examine when it comes to debt. The data is now readily available from sites such as Morningstar and Yahoo Finance. Three key metrics are:

1) Long Term Debt (LTD)

We are usually more interested in Long Term Debt (LTD) than Short Term Debt (STD) in the balance sheet. LTD will gives us an insight of how much the business inherently relies on debt to grow, as distinct from retained earnings. In addition, LTD will be larger and have higher serving costs in dollar terms.

Our practice is to put LTD into our specialist spreadsheets and analytical documents. We then can then study and track it over time, preferably 5 to 10 years. This gives us a feel, and clarity as to its trend.

2) LTD to SE Ratio

LTD should not be seen in isolation. It should be compared with other key metrics. Commonly LTD is compared with Shareholder Equity (SE). This gives us the LTD/SE Ratio.

For example, if Company X has LTD of $48,994m and has SE of $52,269m, then the LTD/SE Ratio is 93.7%. This is also called the Debt to Equity Ratio (DER). A DER of 93.7% is extremely high. The DER should be less than 60%, preferably less than 40%.

A high DER requires further investigation, or it may be an initial filter to not take your interest in this company further. Whether you investigate further will depend on other threshold metrics, such as Earnings per Share (EPS) and EPS Growth over time. In either case, a very high DER is an important issue. It should be highlighted and undertaken early in your analysis.

3) Interest Expense Ratio (IER)

The Interest Expense Ratio (IER) gives us some insight as to how well the company is managing interests costs. We usually study it over time for at least 5 years in our specialist spreadsheets. We compare the Interest Expense (IE) with the Operating Income (OI); the Interest Expense Ratio (IER) is simply, OI / IE.

For example, for Company Y in 2015 the Operating Income (OI) was $15,998 m ; its Interest Expense (IE) was $2,702 m, so the IER was 15998 / 2702 = 16.89%. We do this for at least five years and then determine an average IER. If the average IER is more than 5% we are concerned; if it is greater than 10% we are very concerned.

Avoid Debt Analysis at your Peril

Avoid debt analysis at your peril. In an age where sovereign, corporate and other debt seem so easy to ‘print’ or obtain, many are forgetting the fundamentals. Debt means cost, debt can limit growth, and stifled growth stifles the stock price. Importantly, debt can limit the freedom of management to innovate. In our view, the best companies have little to no long term debt. They grow naturally through the earnings they retain. This has and is always been the purest form of growth, and this is unlikely to change, despite the apparent ease of credit.

 

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