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 Does Corporate Debt Work?
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:
- By issuing fixed-income (debt) securities,like bonds, notes, bills, and corporate papers
- 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 for day-to-day activities. The loan a company borrows from an institution may be used to pay the company payrolls, buy inventoryand 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 amount of debt, 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 meant to repay or refinance old debtsor 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 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 liquidation.
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.
FAQs
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.
How does company debt affect stock price? ›
Equity Value = Stock Price (x) Shares Outstanding. And since Shares Outstanding doesn't change when a company increases debt, the Stock Prices also goes down, canceling out the decline in earnings.
What happens when a company has too much debt? ›
Meaning that if a company cannot pay back its debt, banks are able to take ownership of a company's assets to eventually liquidate them for cash and settle the outstanding debt. In this manner, a company can lose many if not all of its assets.
How does debt affect shareholders? ›
As debt increases, shareholders require higher returns since they face higher financial risk. This higher financial risk results from spreading the firm's business risk over a proportionately smaller equity base.
Do companies issue stock to pay off debt? ›
Issuing new shares can lead to a stock selloff, particularly if the company is struggling financially. However, there are cases when equity financing can be seen as favorable, such as when the funds are used to pay off debt or improve the company.
Will corporate debt drag your stock down? ›
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 happens when a company increases debt? ›
Increasing debt causes leverage ratios such as debt-to-equity and debt-to-total capital to rise. Debt financing often comes with covenants, meaning that a firm must meet certain interest coverage and debt-level requirements.
How risky is a company's debt? ›
The level of risk and return associated with debt and equity financing varies. Debt financing is generally considered to be less risky than equity financing because lenders have a legal right to be repaid. However, equity investors have the potential to earn higher returns if the company is successful.
How do you tell if a company has a lot of debt? ›
- Debt Ratios: Analyze Debt-to-Equity (D/E) and Debt-to-Asset ratios. Higher ratios suggest more debt financing, potentially risky. ...
- Interest Coverage: This ratio shows if a company earns enough to cover interest payments. ...
- Cash Flow: Look at cash flow generation.
How much debt should a small business have? As a general rule, you shouldn't have more than 30% of your business capital in credit debt; exceeding this percentage tells lenders you may be not profitable or responsible with your money.
Shareholders are not personally liable for the debts of the company. The liability of a shareholder is limited only to any unpaid amount of their shares. The directors of the company control the company and its decision making.
Does debt decrease equity? ›
Debt must be repaid or refinanced, imposes interest expense that typically can't be deferred, and could impair or destroy the value of equity in the event of a default. As a result, a high D/E ratio is often associated with high investment risk; it means that a company relies primarily on debt financing.
What happens if a company has more equity than debt? ›
A low debt-to-equity ratio means the equity of the company's shareholders is bigger, and it does not require any money to finance its business and operations for growth. In simple words, a company having more owned capital than borrowed capital generally has a low debt-to-equity ratio.
Should I sell my stock to get out of debt? ›
You won't have to sell your stock to pay off your debt — keeping your long-term financial plan in place — and your low interest rate will prevent your debt from running out of control, making it more manageable in terms of paying it off. One option is to find a 0% balance transfer offer from a credit card company.
What happens to stock price when company issues debt? ›
Risk increases, in part, because the debt could make it harder for the company to pay its obligation to bondholders. Therefore, under a typical scenario, stock prices will be less affected than bonds when a company borrows money.
What does owning 10% of a company mean? ›
A principal shareholder is a person or entity that owns 10% or more of a company's voting shares. As a result, they can influence a company's direction by voting on who becomes CEO or sits on the board of directors. Not all principal shareholders are active in a company's management process.
How does US debt affect stock market? ›
“Eventually, if debt requirements result in more Treasury supply, pushing interest rates higher, that can create challenges for equity markets,” says Haworth. “Higher bond yields may lead investors to put more money into fixed income instruments rather than into stocks, but so far, this hasn't been a problem.”
What happens when a company goes into debt? ›
Companies can file for either Chapter 7 or Chapter 11 bankruptcy if they're unable to pay their debts. Chapter 7 simply liquidates the company's assets, while Chapter 11 allows the business to continue to operate under a reorganization plan.
How does debt affect market value? ›
Debt is often cheaper than equity, and interest payments are tax-deductible. So, as the level of debt increases, returns to equity owners also increase — enhancing the company's value. If risk weren't a factor, then the more debt a business has, the greater its value would be.
How much debt is too much for a stock? ›
Key Takeaways
In general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.
