Long-Term Debt will give investors some insight into how a company should be valued, and whether any company red flags are justified. While most companies take on debt to fund their business and their growth plans, it can also represent increased risk because that debt has to be repaid and it will claim cash flow that could otherwise be used to invest in the company in the future. Additionally, in a recession or industry downturn, the debt could become even more of a burden for the company as their revenues are impacted by economic factors. In this post, we will look at how to evaluate debt as an investor, and various factors to consider before purchasing a company. Obviously debt is only one of many factors to consider, so put debt into context with other factors.
How do you measure Long-Term Debt accurately?
First, let’s take a look at how you can find debt measures for a company. Long-Term Debt shows up on a Company’s Balance Sheet. It is reported quarterly, and you can track the fluctuations of debt as companies take on additional debt or pay it back. A quick definitional note: Long-Term Debt is considered “long-term” if the debt matures more than 12 months into the future. As debt get closer to maturity, it will move from the long-term category and show up in the short term debt line item.
When looking at a company’s debt, evaluating the raw number is not detailed enough, it needs to be put into context. For example, a larger company is usually going to have a much larger debt than a small cap, but it will also have the wherewithal to pay that debt back. Because of this, most analysts and investors look at the ratio Long-Term Debt to Equity. They divide the debt number reported by the company to the company’s equity to compare each companies debt to the size of the company. This helps put the Long-Term Debt number into context, and doesn’t penalize large companies.
What other Factors should I examine?
Another key factor when you are analyzing a company’s Long-Term Debt is to look at their industry. Some industries (e.g. chip manufacturing, energy) are very capital intensive with long payback periods. So it is hardly surprising if a company in one of these industries has a high Long-Term Debt to Equity ratio. So, it makes sense to evaluate Debt to Equity ratio in relation to the Industry Average Debt to Equity ratio.
Cash Flow Growth is also something you want to watch as well. If a company is growing well and throwing off lots of Free Cash Flow, they can afford their debt, and they will have the ability to repay debt.The reverse is also true. Large debt with shrinking cash flow should cause alarm.
How does this fit in the overall picture?
Obviously Debt is only one factor to consider when you are evaluating a stock. In fact, Chaikin Analytics uses a 20-factor model where Long-Term Debt to Equity relative to Industry is one of those factors. Keeping an eye on Debt will help the investor pick companies that have a little less risk. It will also alert you when a company may be facing a cash crunch. But once again, this is just one of many factors that you should use when you evaluate a company.