When it comes to investing in dividend stocks, most people focus on things like growth levels, valuation (P/E), and stock dividends. A wise investor, however, also considers the debt levels of the company that he or she invests in. Debt levels in an organization are not emphasized enough in my opinion so this article shows a few things on the subject.
Debt Metrics
Current Ratio
The current ratio is equal to (current assets) / (current liabilities)
Current assets are assets that should be convertible to cash within a year. Current liabilities are debt obligations that are due within a year. The current ratio is current assets divided by current liabilities, and measures the liquidity of a company over a short time period. Even if a company has a great business, no long-term debt, tons of cash flow, and a great brand, it can still fall into a lot of trouble if it doesn’t keep enough short-term cash available to cover its immediate needs. The higher the current ratio, the safer and more liquid the company is in terms of short-term needs.
Quick Ratio
The quick ratio is equal to (current assets – inventories) / current liabilities
It’s the same as the current ratio except that it doesn’t count inventories in the asset category. This means that the quick ratio is a more conservative estimate of liquidity than the current ratio. The reason inventories are excluded is because depending on the company and its products, inventories may not be readily convertible into cash. The higher the quick ratio, the safer and more liquid the company is in terms of short-term needs.
Debt/Equity Ratio
Out of all the debt metrics, I pay most attention to the Debt/Equity ratio. This is the total company debt (short term debt and long term debt) divided by the shareholder’s equity. Shareholder’s equity is equal to total company assets minus total company liabilities. Typically, the lower the Debt/Equity ratio, the better. A low ratio shows that the company keeps its debt levels low compared to the overall size of the company.
LT Debt/Equity Ratio
The LT Debt/Equity ratio only uses Long-term debt in its calculations, instead of total debt, but is otherwise the same as the Debt/Equity ratio. Long-term debt is debt that has more than a year to pay off.
Interest Coverage Ratio
When a company has debt, it has to pay interest on that debt. The interest coverage ratio shows how easily it can pay its interest. It is calculated by dividing the EBIT (Earnings before interest and taxes) by the total interest expense of that period. So if a company makes $5 million in pre-tax, pre-interest earnings, and has to pay $1 million in interest during that period, then it has an interest coverage ratio of 5. The higher the number, the better.
The reason this interest coverage ratio is important is that not all debt is the same. Companies have credit ratings just like people do, and they can get better interest rates on certain types of debt. A company with a great financial position can borrow money with a rather low interest rate, while a company with a poor financial position will have to pay more interest on the same amount of borrowed money.
A debt example
I pay a lot of attention to debt because I want to make sure my companies are healthy and able to take advantage of good opportunities for growth. Here’s a theoretical example of why low debt is better. It’s not meant to be hugely realistic, but instead just to get the point across.
Company A
Annual net earnings: $10 million
Total Assets: $50 million
Long-term Debt: $0
Company B
Annual net earnings: $10 million
Total Assets: $50 million
Long-term Debt: $20 million
Both companies are identical, except company B has more debt. Company A has a LT Debt/Equity ratio of 0 while Company B has a LT Debt/Equity ratio of 0.667. In a scenario like this, a lot of novice investors may pay little attention to debt levels. But consider this- Company A could theoretically increase its earnings by issuing debt to make an acquisition. If Company A issues $20 million in debt, uses that $20 million for which it pays 10x earnings for a company, then it can acquire a company that earns $2 million per year in earnings. For my assumption, I assume the acquired company has $5 million in assets and no debt.
After the above transaction, the two companies now look like this:
Company A
Annual net earnings: $12 million
Total Assets: $55 million
Long-Term Debt: $20 million
Company B
Annual net earnings: $10 million
Total Assets: $50 million
Long-Term Debt: $20 million
Now, they have equal debt levels, but Company A has more assets and higher earnings. Of course, a scenario that is this simplistic never really occurs, but the point is that companies in a stronger financial position have more theoretical and practical growth opportunities available to them. During difficult economic times, they can invest more into their business at great prices.
Is all debt bad?
No. Some companies make good use of debt. A company that has a lot of debt is usually an unattractive investment, but some companies can use debt to their advantage.
Some companies, like Johnson and Johnson or Coca Cola, are companies that have been around for ages and could have paid off any debt decades ago. They keep modest amounts of debt on their balance sheets anyway, because they know they can use that money to get better rates of return. It’s like a person continually borrowing money with a 5% interest rate and then using it to develop 15% rate of return on that money. While this does add risk, it also gives the possibility of accelerated growth. As long as it’s kept in moderation (as in the case of these two companies), this is not a problem.
Other companies, like utilities, require huge initial investments and therefore often have large amounts of debt. This is generally offset by their stable levels of income, as long as management is prudent. So when utilities have a lot of debt, it’s not necessarily a sign of trouble, but it’s still worth paying attention to.
Full Disclosure: I own shares of Johnson and Johnson and Coca Cola.
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