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2012-11-02 09:55:27
September 24 2009| Filed Under Bonds, Debt, Fundamental Analysis, Investing
Basics, Personal Loans, Stock Analysis
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 take a look at how you can evaluate whether the debt
will affect your investment.
How Do Companies Borrow Money?
Before we can begin, we need to discuss the different types of debt that a
company can take on. There are two main methods by which a company can borrow
money:
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 in order to meet their cash requirements of day-to-day activities. The
loan a company borrows from an institution may be used to pay for the company
payrolls, buy inventories and new equipment, or to 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
There are a few obvious things that an investor should look for when whether
deciding to continue his or her investment in a company that is taking on new
debt. Here are some questions you can 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 surplus in cash. Furthermore, high debt levels may
negatively affect common stockholders, who are last in line for claiming
payback from a company that becomes insolvent. (For more insight, read
Evaluating A Company's Capital Structure.)
Watch: The Debt To Equity Ratio
What kind of debt is the company trying to take 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 a 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 a company is taking on meant to repay or refinance old debts, or 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 are 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
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 enough to meet its debt obligations. And do make sure the
company has diversified its prospects. (For more on how to analyze corporate
debt and refinancing, read Debt Reckoning.)
Are there any special provisions that may force immediate pay back?
When looking at a company's debt, look to see if there are any loan provisions
that 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
stated ratios of the company 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 a liquidation state.
How does the company's new debt compare to its industry?
There are many different fundamental analysis ratios that may 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 of 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.
Conclusion
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.