Debt Analysis and Financial Health

Debt is a double-edged sword. Used wisely, it accelerates growth. Used poorly, it destroys companies. Understanding a company's debt load is essential for avoiding potential disasters. [DEFINITION] Leverage: The use of borrowed money (debt) to finance operations or investments, amplifying both potential gains and losses. ### Why Debt Matters **Benefits of Debt:** - Lower cost than equity (interest is tax-deductible) - Amplifies returns on equity - Enables faster growth **Risks of Debt:** - Interest payments are mandatory - Principal must be repaid - Covenants restrict operations - Bankruptcy if can't pay [KEY] In good times, debt boosts returns. In bad times, debt kills companies. Always consider both scenarios. ### Key Debt Metrics **Debt-to-Equity Ratio** [FORMULA] Debt-to-Equity = Total Debt ÷ Shareholders' Equity | Ratio | Interpretation | |-------|----------------| | Under 0.5 | Conservative, very safe | | 0.5-1.0 | Moderate, typical | | 1.0-2.0 | Higher leverage | | Over 2.0 | Aggressive, risky | **Interest Coverage Ratio** [FORMULA] Interest Coverage = Operating Income (EBIT) ÷ Interest Expense | Ratio | Interpretation | |-------|----------------| | Over 5x | Very safe | | 3-5x | Comfortable | | 2-3x | Watch carefully | | Under 2x | Danger zone | [EXAMPLE] Company Analysis: - Operating Income: $100 million - Interest Expense: $20 million - Interest Coverage = $100M ÷ $20M = 5.0x This company can comfortably pay interest, even if profits drop 50%. **Debt-to-EBITDA** [FORMULA] Debt-to-EBITDA = Total Debt ÷ EBITDA | Ratio | Interpretation | |-------|----------------| | Under 2x | Low leverage | | 2-4x | Moderate | | 4-6x | High leverage | | Over 6x | Very high risk | [TIP] Banks and rating agencies often focus on Debt-to-EBITDA. Loan covenants frequently require staying under a certain ratio. ### Types of Debt to Analyze **Short-Term Debt (Due within 1 year):** - Commercial paper - Credit lines - Current portion of long-term debt - Most concerning for liquidity **Long-Term Debt (Due after 1 year):** - Bonds - Bank loans - Lease obligations - Check maturity schedule [WARNING] A "debt maturity wall"—large amounts due in one year—is dangerous. Companies must refinance, which may be expensive or impossible in bad markets. ### Debt Maturity Schedule [EXAMPLE] Company debt maturities: | Year | Amount Due | |------|-----------| | 2024 | $100M | | 2025 | $50M | | 2026 | $200M | | 2027 | $300M | | 2028+ | $500M | 2027 is a concern—$300M due. If credit markets freeze or the company struggles, refinancing could be difficult or expensive. ### Credit Ratings Rating agencies (S&P, Moody's, Fitch) assess default risk: | S&P Rating | Moody's | Risk Level | |------------|---------|------------| | AAA | Aaa | Highest quality | | AA | Aa | High quality | | A | A | Upper medium | | BBB | Baa | Medium (lowest investment grade) | | BB | Ba | Speculative | | B | B | Highly speculative | | CCC/CC/C | Caa/Ca/C | Substantial risk | | D | C | In default | [KEY] "Investment grade" is BBB-/Baa3 or higher. Below that is "junk" or "high yield." Many institutional investors can only hold investment grade debt. ### Industry Context Matters Appropriate leverage varies by industry: **Low debt appropriate:** - Cyclical businesses (auto, retail) - High-growth tech - Early-stage companies **Higher debt acceptable:** - Utilities (stable cash flows) - Real estate (assets as collateral) - Consumer staples (consistent demand) [EXERCISE] A company has Total Debt of $2 billion, Shareholders' Equity of $3 billion, and EBITDA of $800 million. Calculate Debt-to-Equity and Debt-to-EBITDA. Is this leveraged appropriately? |ANSWER| Debt-to-Equity = $2B ÷ $3B = 0.67x (moderate). Debt-to-EBITDA = $2B ÷ $0.8B = 2.5x (moderate). This appears reasonably leveraged—not conservative but not dangerous for a stable business. [SCENARIO] You're comparing two companies: | Metric | Company A | Company B | |--------|-----------|-----------| | Debt-to-Equity | 0.3x | 2.0x | | Interest Coverage | 15x | 3x | | Profit Margin | 15% | 20% | Company B has higher margins but much more debt. In a recession, Company A survives easily while Company B might struggle to pay interest. Unless you're confident the economy stays strong, Company A is safer despite lower margins.