Debt in Business Analysis
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 then 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 prospective, 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.