Stock Research Checklist – Debt

Debt is an important part of business. If it manageable debt, then it is acceptable. If the debt load is very high, it will be very hard for that business to succeed, sometimes the company will even end up in bankruptcy. The investors will end up losing all their money. Some industries are capital intensive, they have to use debt to finance their capital investment apart from equity capital. For example, industrial and manufacturing companies need to invest large amounts of money for factories in order to keep them up to date.

Does the Company have Manageable Debt?
If you find a capital intensive business at a bargain price. Here you can compare that company’s debt level with a direct competitor. If the company can pay off total debt with five years of net income, then that should be a manageable debt. Find out when the current debt is coming due. If any debt is due within a couple of years, what kind of plan does the company have to pay off that loan? When the company has debt as a bond, it is less risk to the company. Long term bonds are a good kind of debt to have.

The economy goes through life cycles: recessions, recoveries and boom periods. If a company loads up on too much debt during boom years, it can generate a higher revenue and be able to service debt. When it enters into a recession, it will be hard to cut costs and reduce the debt as fast as the revenue decreases. It will be hard to handle the debt when the recession period starts.

Does the Company have Manageable Short-Term Debt?
Short-term debt translates into whatever debt a company needs to pay before one year. It appears on a balance sheet’s current liabilities. This may be interest that needs to be paid on long-term debt. If any debt comes due, the company should have money to cover that debt. The company should have cash and cash equivalents, short-term investments, accounts receivables, hidden assets and cash flow numbers to pay the short-term debt. If the company does not have enough cash to cover that short-term debt, do not even look at the company because it may a sinking ship.

What is the Company’s Current Ratio?
Current ratio helps you to find out whether or not a company has the ability to pay current obligations.

The formula of Current Ratio = Current Assets / Current Liabilities

What is the Company’s Long Term Debt? Is it Manageable?
As a first choice, investors should look for companies that do not have long term debt. The companies may not have long term debt for any of the following reasons.
  1. The company is operating in an industry where it does not need to spend a lot of money on capital expenditures.
  2. Search for these kinds of companies because they can create more shareholder value over the long term. There is no risk of default because they have no longer term debt. Plus, company earnings are not reduced because of interest payments on long term debt.
  3. The company may be in a sustainable competitive position to earn a higher profit and, in turn, generate a higher cash flow every year. Management can fund the growth of the company from existing cash flow rather than relying on debt. This kind of business is good and generates higher shareholder value over the long term.
  4. When the input costs increase, sustainable-competitive-position companies can raise the prices and still maintain a decent profit. That is, management can expand the company via internal growth and spend capital expenditures from company profits rather than depending on debt. Companies like this can generate excellent value for shareholders over the long term. If you can identify companies with no long-term debt and a competitive position at attractive pricing, you should invest and hold those companies for the long term to generate a great return.
Reasonable debt means the company is able to repay the whole long-term debt within four or five years of net income. The best kind of debt is in corporate bonds with long term maturities and low interest rates. Investors cannot demand the principal payments immediately and also management can defer the interest payments.

Does the Company Pay Little or Not Interest Expense?
Durable, competitive companies pay little or no interest expenses for their short and long term debt. If a company does not spend money on its interest expense, this is good because it is a zero debt company. Reasonable amount of interest expense is acceptable, need to find out what percentage of operating income is spent as an interest expense. Determine whether this is consistent percentage or going down. If it is going up, this is a bad sign.

Does the Company have Preferred Shares?
Preferred shareholders have a higher claim on the capital structure of the company. They get paid a fixed dividend and have conversion rights to common stocks. If the company is in liquidation, preferred stockholders will have claim before the common stockholders get paid. This form of preferred stock is a costly form of debt because the company needs to pay the interest and have an equity appreciation potential for the preferred stockholders.

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