CLASSES TO GO!

Company Debt: A Shot in the Arm or a

Prescription for Disaster?
Ann Cuneaz
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Disclaimer
• The information in this presentation is for educational purposes only and is not
intended to be a recommendation to purchase or sell any of the stocks, mutual funds,
or other securities that may be referenced. The securities of companies referenced
or featured in the seminar materials are for illustrative purposes only and are not to
be considered endorsed or recommended for purchase or sale by BetterInvesting™
National Association of Investors Corporation (“BI”) or the BetterInvesting Volunteer
Advisory Board, its volunteer advisory board (“BIVA”). The views expressed are
those of the instructors, commentators, guests and participants, as the case may be,
and do not necessarily represent those of BetterInvesting™ or BIVA. Investors
should conduct their own review and analysis of any company of interest before
making an investment decision.

• Securities discussed may be held by the instructors in their own personal portfolios or
in those of their clients. BI presenters and volunteers are held to a strict code of
conduct that precludes benefiting financially from educational presentations or public
activities via any BetterInvesting programs, events and/or educational sessions in
which they participate. Any violation is strictly prohibited and should be reported to
the President of BetterInvesting or the Manager of Volunteer Relations.
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WHAT IS DEBT?
• Money borrowed by one party from
another
• Money that must be paid back at a
later date, usually with interest
• Provides means to make large
purchases not possible under
normal circumstances
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PERSONAL DEBT

• Mortgage
• Car loan
• Student loan
• Credit card debt
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COMPANY DEBT
• New factories
• Expand to new location
• Computer systems
• Acquire a company
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DEBT AS A SHOT IN THE ARM

• Financing new projects that have

potential to increase revenues
• Refinancing debt at lower interest rate
• Rate of return is higher than the
interest rate at which money is
borrowed
• Kept at moderate level
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OR PRESCRIPTION FOR DISASTER?

• Taking on more debt, when current debt

level is substantial
• Unable to pay operating expenses
without additional debt
• Repeatedly refinancing old debt
• Cost of debt is HIGHER than the rate of
return
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Provides Heavy
financial burden in
resources times of
for company economic
growth and recession.
expansion.
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HIGHER DEBT
 HIGHER RISK
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WHAT IS TOO MUCH?

• $9 Million?

• $90 Million?

• $9 Billion?

It depends!
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CAPITALIZATION RATIO
• Long-term debt as % of capital
structure
• Capital structure = LT debt + equity

Long-term Debt
=
Long-term Debt + Shareholders’ Equity
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CAPITALIZATION RATIO
• Low rate indicates “strong”
balance sheet
• In general, less than 35% is desired
– Varies by industry
• Reported on Stock Selection Guide
• Companies with high ratios said to
be highly leveraged
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INTEREST COVERAGE
• Indicates if company can afford the
debt
• Measures how many times
company earnings could pay
interest expense
• Low ratio indicates debt expense
may be a heavy burden.
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INTEREST COVERAGE
• 10x means that earnings are 10 times
larger than interest expense
• Coverage of 7x or 8x should be
adequate for most companies
• Under 5 is a warning sign
• Under 3? Big RED flag

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Total interest coverage =

Pretax Profit + Tot. Interest Pd.

Tot. Interest Paid

*
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INTEREST COVERAGE

11.7x 1.9x

If the economy slows and business falls off,

which company is more likely to go bankrupt
because they can’t service their debt?
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COMPANY LIQUIDITY
• Ability to pay day-to-day bills
• Indicates how prepared company
is to pay bills that come due over
the next year
• Measured by the Current Ratio
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CURRENT RATIO
• Current assets: assets turned into cash
within 1 year.
– Cash, marketable securities, accounts
receivable, inventory
• Current liabilities: debt or obligations due
within 1 year.
– Account payable, current portion of long term
debt, accrued expenses (including taxes)

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CURRENT RATIO
• Current Assets  Current Liabilities
• If current assets = $500,000, and current
liabilities = $250,000, current ratio is 2:1
– For every $1 of current debt, there are $2 of
current assets to meet obligation
• In general, want 2:1, or higher
– But consider industry averages

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FINDING THE CURRENT RATIO

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EVALUATING DEBT
• How much debt?
– Capitalization ratio (less than 35%)
• Can company afford the debt?
– Interest coverage (7 or more)
• Is company able to pay the bills?
– Current ratio (2 or more)
• Guidelines may vary by industry
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REFERENCES
• Using Portfolio Management
Wisdom Handbook, Bonnie
Biafore, BI Educational Series

• Financial Ratio Tutorial,

www.investopedia.com/university/rati
os/default.asp
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