In order for young companies to grow, they must have ample capital on
hand to expand the business and take care of daily operations. For most
companies, this means resort to the debt markets as a means of getting
the necessary capital. There is nothing wrong with this, and it is a
trademark of our vibrant economy that such a market exists. However,
too much debt can crush a company. Here is a more detailed explanation
of debt and some warning signs that a company might be buried in it.
What Type of Debt
There are two main ways a company can take on debt: 1) by issuing debt securities like bonds- and 2) by obtaining a bank loan.
- Debt Securities- These securities are issued by the company and
purchased by investors. If you were the buyer, you would basically be
lending money to the company for a given interest rate. Debt securities
typically enable a firm to raise more money and to borrow for longer
durations than loans typically allow. However, the downside to this is
that these issuances usually dilute existing securities and push prices
lower in the short term.
- Loans- Bank loans dont involve the dilution risk that debt
securities do, but they usually require repayment over a much shorter
time period. An advantage of this type is an open line of credit that a
company can use to meet day-to-day needs. Be aware of how much
loan-debt a company has and what the maturity dates are.
Be On the Lookout
When researching a company, be on the lookout for these items:
Purpose of the Debt
If a company keeps borrowing to pay off
existing loans, there could be serious trouble on the horizon. A
company in this situation is likely headed for bankruptcy as costs are
exceeding revenues, and the only they see to get out of their hole is
to keep digging.
On the other hand, a healthy, growing company
will take on debt to finance new projects and initiatives. These new
projects are the lifeblood of a young growth company, and will be the
basis for self-sustenance going forward.
Existing Debt Levels
Check the balance sheet to ascertain how
much debt the company already has. A debt-free company has plenty of
latitude to take on debt to finance new projects. This is acceptable
and even encouraged. A young company that is hesitant to take on any
debt is probably too conservative and stands little chance of being a
huge winner. Of course, the likelier scenario is a company that is
already loaded with debt, and is itching to add to it.
Gauging Debt Levels
Here are a few methods to quantify the debt levels of prospective companies:
Quick Ratio:
This ratio is a test that indicates whether a firm has enough
short-term assets to cover its immediate liabilities without selling
inventory. It can be calculated as follows:
This ratio should be comfortable over 1, and preferably much higher.
Current Ratio:
This ratio measures how much coverage short term assets have over short
term liabilities. A general rule of thumb is that two or better is
preferable. It can be calculated as follows:
Debt to Equity Ratio:
This ratio measures what proportions of equity and debt are used to
finance a companys assets. Acceptable levels vary across industries,
with capital intensive industries often having ratios over two, and
computer companies having ratios less than 0.6. The ratio can be
calculated as follows:
Assessing
debt levels is more an art than a science. However, being knowledgeable
about various ratios and guidelines can help you spot red flags before
a company gets buried by its debt load.
