5 Things You Need to Know When Analyzing Corporate Debt

One of the most important things to look at when analyzing a prospective investment is the financial health of the business. Companies with a lot of debt and little cash flow are candidates for bankruptcy, leaving your investment worth nothing, regardless of how much you paid per share of stock. On the other hand, strategic debt can often help greatly improve a business's growth rate, and is almost required for start-up and early-stage companies. In this article, I'll go over 5 basic questions related to analyzing a company's debt burden, including what it is, and what is good or bad debt. In a follow up article, I'll go through a Magic Formula example to illustrate the process.

1) What kinds of debt do businesses use?

There are many different kinds of debt, but in general there are 3 primary forms. The first is simply a line of credit from a bank, often referred to as a "credit facility". This is not much different from a consumer credit card. The bank grants a business the ability to borrow up to a certain amount of money on a short-term basis with usually rather high interest rates. You can find the outstanding amounts on a line of credit in the balance sheet in the current liabilities section, usually under "short-term debt" or "line of credit".

The second, and probably most common method of debt are long-term corporate bonds. These are underwritten by an investment bank, rated by a debt rating agency like Moody's (MCO) or S&P (MHP), and sold to investors. The company then (usually) pays quarterly or annual coupons on the bonds, with a rate determined both by the bond risk rating and the general interest rate environment at the time of issuance. At some point in the future, usually 5 years or more, the bonds mature and are paid off. Bonds are a pretty involved topic with lots of variables outside of the scope of this article.

The third form of debt is an offshoot of bonds that is frequently encountered: the convertible bond. A convertible bond usually carries a lower coupon (interest) rate than a traditional bond, but it has the feature of being convertible to shares of stock at a certain price. Convertible bonds are attractive to the company as they require lower interest payments, but are less attractive to existing shareholders as they represent potential share dilution of profits - a smaller portion of the pie. Again, this is a general description and there are many variables to consider with convertible bonds.

Both long-term corporate bonds and convertible bonds can usually be found on the balance sheet under "long-term debt", although bonds redeemable within a year show up in the "current portion of long-term debt" line item. To find the breakdown of a company's debt types, look in the "Notes to financial statements" section, as there is usually a note dedicated to listing out each individual component of debt.

2) Why do businesses take on debt?

The two primary reasons a company takes on debt are to finance start-up operations or growth initiatives. Few entrepreneurs have enough out-of-pocket cash to finance business start-up costs, so debt is almost always present in early stage companies. For more mature companies, debt is often employed to pursue growth, usually through acquiring other businesses, building more store locations, building a new factory to expand production, and so forth. This provides the capital to grow faster than would otherwise be possible by using only cash flows generated from existing operations.

Managers often refer to debt as "leverage", and examining this definition can illustrate how using debt can greatly improve investment returns. For example, say you invested $1,000 of your own money and sold the investment a year later at $1,200 for a 20% gain ($200). Now, say instead you borrowed $800 at 7% annual interest rate, and put in $200 of your own money into the same investment, selling at the same $1,200. You would have to pay back $856 for debt + interest, leaving you with $344. Subtract out the $200, leaving you with a $144 gain. That's a $144 gain on just $200 of your own capital - a 72% return on investment, way better than 20%. Now carry this example into the scale of millions of dollars and you can see why "leverage" is an attractive concept for business managers!

3) How can we tell if debt is being properly utilized?

In a nutshell, debt is being efficiently utilized if the investment it is being used for is providing a higher return on capital than the cost of the debt itself (the interest rate). Again, this might be best illustrated in a personal finance example. Say you have the ability to borrow money from a bank at a 3% annual interest rate, and you know you can put that money into a 12-month CD that yields 5%. It makes sense to borrow and buy the CD, as the interest paid from the CD will exceed the amount owed on the debt by 2%, providing you with an arbitrage profit.

Clearly, this isn't a good idea in personal finance unless you are dealing with large amounts of money. From a business perspective, a manager needs to make sure that the factory he is building or the company he is buying with new debt will provide him a return that exceeds the cost of borrowing. Here is where a lot of companies get into trouble, taking on leverage to make large business purchases that do not fit into the existing company's core competencies and thus providing low returns on capital.

4) What should one look for when analyzing stocks?

First of all, a large number of companies out there do not use debt at all, and that's the best case scenario. Without debt, there is no immediate bankruptcy risk. Companies that finance growth using cash flow alone are the most attractive and safe investments, but one must be sure that cash flows provide sufficient capital to grow, especially in very competitive markets where competitors willing to use debt could establish a better competitive position.

For firms that do use debt, the main thing to look at are current debt liabilities (lines of credit and maturing long-term debt) against cash resources. It's these short-term debt requirements that can get a firm into serious trouble. Add the short-term debt liabilities up and compare them against cash on the balance sheet and free cash flow. Does cash cover the short-term liabilities at least once over (and preferably by 150% or more)? If not, you might want to steer clear... this is probably not a safe investment.

Interest coverage ratio is another thing to look at. Look at the income statement and compare the "interest expense" line with "operating earnings". You want to see operating earnings at least 5 times as much as interest expense. Anything lower and the company has so much debt interest to pay that its business operations are barely supporting it.

Lastly, be very wary of heavily cyclical companies like commodity firms that have high debt burdens. These firms can see dramatic and quick fall-offs in sales and profits, making what once seemed like easy interest payments into heavy burdens. With these cyclicals, always try to determine what the trough profit and cash flow levels look like and compare those against debt requirements.

5) What is an MFI example of analyzing business debt?

Glad you asked! MagicDiligence will post a follow-up article with a detailed example of analyzing the debt of a current Magic Formula stock, Deluxe Corporation (DLX). Check back later this week for that one.

Disclosure: Steve owns no position in any stocks discussed in this article.

Comments

[traden4alpha:]

Excellent Post!

First, one can also think about the duration of any debt relative to the cash assets and cash-flow of the company. All debts must be repaid (or rolled into new debt) and that creates risk if the company does not have enough cash to repay the debt. This crisis shows that companies can't assume that credit will always be easy to get. And if/when inflation rears it's ugly head, then rolling a debt might become extremely expensive. The point is that if a company has debt that's due in 5 years, for example, it should be creating cash-flow sufficient to repay the principal on that debt in 5 years.

Second, equity investors are last in line for the profits and assets of the company. The greater the debt, the longer the line of claimants standing in front of the equity investor. That's why equity investors need to think carefully about indebted companies.

Sep 02 07:52 AM

[skipper54:]

Thankyou for talking at a level I can understand as a relative newcomer to the equity market. I shall now attempt to read the balance sheet of a drybulk shipping company bearing the above in mind. One thing though is the relationship between debt and asset value (in this case ships). Presumably if the value of assets is much higher than the debt then the company is in good shape. But who is to say that those assets are properly valued ? My gut feeling is that ALL shipping companies have their assets overvalued due in part to the volatility of the market but also to the relative lack of sale and purchase deals which might serve to establish realistic ship values. So where does that leave the investor ?!

Sep 02 08:39 AM

[Positroll:]

And then there is debt that isn't really debt - GAAP accounting just makes it look like debt.
Take e.g. PNCL - a short glance at the balance sheet makes it look kinda ugly, while the truth is completely different: deferred revenue liability of $216M out of the sale of Northwest Airlines bankruptcy claim with no obligation to deliver any services associated with the deferred revenue.
seekingalpha.com/artic...
( a little old; adjusted tangible book value is now somewhere north of $12 / share, not the $9.11 indicated in the post)
But of course, most investors don't take the time for this kind of scrutiny, esp if the company is in a unliked business (airlines in this case) ...

Sep 02 09:28 AM

[Shorewood:]

<< In a nutshell, debt is being efficiently utilized if the investment it is being used for is providing a higher return on capital than the cost of the debt itself (the interest rate). >>

The appropriate hurdle rate for projects that are "financed with debt" is not the cost of the debt, but something higher, commensurate with the risk of the project. The borrower could not issue debt without first having some higher-cost equity: So, some of that higher cost should be added to the cost of the debt.

A debt issue increases the risk borne by stockholders and raises their required rate of return, the cost of equity capital. This additional cost of equity is rightly added to the interest cost of the debt.

Sep 02 09:59 AM

[sod:]

This is information I probably will never use, but was it is delightful reading. Wonderful article. Look forward to coming articles.

Sep 02 10:45 AM

[jarco:]

Your article is a good primer for the full semester MBA course generally titled "Financial Management”. There the subject is broadened to the debt/equity balance.

Of further interest to your readers should be two other aspects when evaluating a prospective investment in a company; namely, debt: equity ratios and debt service coverage. For bond investors especially, the latter is paramount for not only for the current quarter statements but for recent history as well. It pays to either follow a company for a while and/or so some historic research that can become a challenge at times.

Sep 02 11:44 AM

[John T.:]

Back in the dark ages, bank lenders would establish 'lines of credit' for seasonal or specific usage. A hardware store might purchase a batch of lawnmowers in February at a low price from the distributor and repay the amount on the line from their sale in April and May. Perhaps lacking sufficient capital, they would 'rent' the cash and make a profit on the mark-up less the interest (rent) when they paid down the line in May and June. When the short term 'line of credit' turned into a problem is when it became " not much different from a consumer credit card " as the author says, and it was used non-specifically.
I know this is 'Commercial Banking - 101', but eventually with larger corporations, these Lines of Credit without specific repayment sources morphed into short-term corporate commercial paper whose only source of repayment when hard times loomed was
as problematic as a consumer refinancing credit card debt into a HELOC, and then 'terming it out' with a sub-prime mortgage. Sound corporate credit extensions turned into loans extended under the 'greater fool' theory of loan repayment. I think we need to look at the causes of this degradation.

Sep 02 11:50 AM

[Howard_T:]

I can think of one more reason why companies take on debt, and it's especially prevalent in defense industries and others that do business with the government. A defense contractor doesn't get paid until it has performed on a contract. That doesn't mean the entire contract, but there are incremental stages that must be satisfied in order to earn partial payments. This means that the contractor has to pay his staff, keep the lights on, heat (or air condition) the buildings, buy the material necessary to build the product, and so on. In the meantime, the government hasn't given him a dime until he satisfies the necessary progress metrics. Thus, the contractor lives on borrowed money, paying it back with his returns from his customers.

When you look at R & D, the situation is worse. Now you haven't even got a contract, but you have to pay your engineers and scientists. The next time you want to scream about why the government has to pay so much for military hardware, consider "the cost of the money".

Sep 02 01:45 PM

[zagrebzagreb:]

Another 'hidden' form of debt are lease agreements.... These are generally off-balance sheet numbers that are found in the notes sections.

Think of it like this: If you buy a car with a loan from a bank, you still have an obligation to pay. Similarly, if you lease a car, you still have an obligation to pay... Ownership questions, maintenance, etc are different, as well as payment schedules, but in most respects its a similar arrangement.

A lot of companies use leases extravagantly - think of arilines that usually lease planes, rather than purchase them. Microsoft too (often portrayed as essentially debt free, and better for it) has huge lease agreements that drain their accounts...

So... Debt free, just because of a line item on the balance sheet says so? Not necessarily.

Sep 02 03:39 PM

[Danny Newton:]

No highway Department could withstand this scrutiny of their debt utilization. It is very typical to pay for new infrastructure and have no way that the concurrent cash flow in terms of tax money per vehicle mile traveled actually exceeding the initial cost and ongoing maintenance. There are reports that some highway departments are using stimulus money for and payrolls.

The stimulus package, as it pertains to transportation spending, targets underperforming counties and cities or areas with median income below 80% of the national average. This assures that money will be spent in areas with low probability that the new infrastructure will actually pay for itself. Instead of trying to get the greatest good for the greatest number, the spending tries to optimize the dollars spent regardless of the possibility of a return on investment.

Hopefully, the respent dollars by contractors and their employees will be handled with greater sophistication and care.

Sep 02 03:48 PM

[LKofEnglish:]

interesting comment on lease agreements. it's how almost the entire trucking industry is run, too. bottom line the entire nation and its economy runs on debt and looking at debt really tells little about the business in and of itself since as with the nation most of them are bankrupt already. so in case anyone was wondering "why the bailout" well, now you know.

Sep 02 04:24 PM

[Nettligent:]

I am more interested in less and huge debts ridden companies. Good posts. If it is possible, can you analyze the following companies as examples: CSCO SNDK SYMM

Sep 02 04:33 PM

[Gregman2:]

Excellent article, and some great comments.

Sep 02 07:22 PM

[Matt Stone:]

Thanks for the article.

Sep 03 01:17 AM

[Fighting Yoda:]

Another important aspect of debt is 'debt covenants' - what conditions are attached to the debt. There could be provisions of debt recall or interest rate getting reset higher on- a credit downgrade or occupancy falling, etc. Second- ‘when is debt coming due’ - if the environment is bad - the company may not be able to roll over the debt. These two aspects are the biggest causes of bankruptcies; cash flow issues (interest payments) can be solved somewhat more easily by issuing more debt, but principal repayments (unable to rollover debt) is the big problem.

Sep 03 02:07 AM

[Andrei Babn...:]

Good read - short and to the point.

To adjust for operating leases, I would recommend the following tool:
www.stern.nyu.edu/~adamodar/pc/oplease.xls

On the point of debt maturities, most company's disclose their debt maturing profile for the next five years. It is usually represented as debt due within 1 year, debt due within 2 years, debt due... etc. You should analyze those "buckets" to see when majority of debt is maturing to see if the company may face refinance risk down the road. Typically companies try to push their maturity profile as far as possible, but not too far if pricing is expensive (as it is now), while bankers would rather lock in a longer tenor at this point to receive more fees (interest income).

Another point not mentioned is that often large corporations such as Disney or Time Warner for example will use debt to purchase their own shares to return value to the shareholders.

Sep 03 02:09 AM

[elliot_mllr:]

If/when inflation rears its ugly head, the debtor will be paying off the debt with cheaper, devalued dollars than those it borrowed.


On Sep 02 07:52 AM traden4alpha wrote:

> Excellent Post!
>
> First, one can also think about the duration of any debt relative
> to the cash assets and cash-flow of the company. All debts must
> be repaid (or rolled into new debt) and that creates risk if the
> company does not have enough cash to repay the debt. This crisis
> shows that companies can't assume that credit will always be easy
> to get. And if/when inflation rears it's ugly head, then rolling
> a debt might become extremely expensive. The point is that if a
> company has debt that's due in 5 years, for example, it should be
> creating cash-flow sufficient to repay the principal on that debt
> in 5 years.
>
> Second, equity investors are last in line for the profits and assets
> of the company. The greater the debt, the longer the line of claimants
> standing in front of the equity investor. That's why equity investors
> need to think carefully about indebted companies.

Sep 05 05:52 PM

[David Tsao:]

Great write up, thanks for posting.

Oct 17 09:17 PM