Sunday, November 05, 2006

Debt And Equity

When looking at any company you need to evaluate its debt levels. To me this is one of the most important aspects of fundamental analysis as a company with too much debt intriduces a lot of risk to the share price and in extreme cases it can lead to bankruptcy.

When looking at the debt levels of the company there are several things to examine. These include:

  1. Debt to Equity ratio
  2. Return on Captial vs Return on Equity
  3. Interest Cover
  4. Cash at Bank vs Interest Payments

The debt to equity ratio is a good indicator on whether a company is carrying excessive debt. You need to understnd the debt requirements for the industry as certain industries require high amounts of debt. To make sure you judge the debt to equity ratio properly you should compare it to the industry standard. if it is higher then the industry standard then you may need to take a good look at the reasons why it is high and maybe pass ont his share.

Debt is used by management to leverage the gains for Return on Equity. The ROE should always be higher than the ROC. If it is not then management is not using debt well and it is costing the company money. If you find any share where the ROC continually exceeds ROE then that means you have incompetent managmeent and you should not touch this share until management is changed or starts to work out what they are doing wrong.

Interest cover must be examind for any company that has debt. It tells us how many times the earnings cover interest payments. I would be looking for at least 8-10 times to be in a safe level. Any lower than this and the company is flirting with danger.

The last thing that should be examined is the cash at the bank. If the company needs to pay out 1 million a month in interest and there is only 4 million in the bank you can be a bit worried. Anything higher that shows interest payments are higher than 20% of the cash at the bank can be a issue and may lead to danger in the future. 20% is fairly high and would want to be your maximum. There is always a risk to the company that people won't pay on time or won't pay at all so you need to make sure the company can survive a while in a sudden downturn.

Well thats what I look at when examining debt in a company.

No comments: