Debt Management and Value Investing

A Key Measure is Debt to Equity

The measures of debt management are debt to equity and interest cover ratios. They are a guide to a company's debt management capability, including its ability to handle the interest on the debt.

Both measures are readily available on online brokers' websites and are used in value investing to find companies with low or zero debt.

How do I use them? A debt to equity ratio above 40% could spell danger of excessive debt. It could, however, relate to the funding of a recent acquisition.

Future earnings related to the acquisition may reduce the debt level swiftly in following years.

Interest cover indicates to what extent the cost of the debt, namely the interest payments, is covered by earnings.

It is generally considered that cover should be greater than two to provide a sufficient buffer. That is, the company's earnings should be greater than twice the interest payments on the debt.

Some companies are debt free, or are in a position to get out of debt quickly, because of strong cash flows. Warren Buffett likes low-debt companies. It's all about minimising risk.

The recent global financial crisis (GFC) was all about excessive debt. This has caused some companies to go broke and others to scramble to make capital raisings or offer rights issues.

I also look to see that long-term debt does not exceed three to four times the net profit of the company. This indicates that repayment of the debt from profits will not be onerous.

Generally I look for companies with good (and stable) earnings per share growth and low debt as value investing is about risk minimisation. Companies with low or zero debt carry less risk.

'Growth' companies that are aggressively acquiring other companies may have good earnngs per share growth as well as higher debt. They risk having problems 'bedding down' an acquisition, partically if it is a large one.

So it is important to keep abreast of what a company is doing by reading the financial press and the company's announcements. I also keep an eye on the the past ability of 'growth' companies to 'bed down' acquisitions.

This enables me to obtain a clearer understanding of a company's debt position and the reason(s) for it.

Return from Debt to Equity to Financial Ratios