In this article, I'll cover how to effectively analyze company debt, how debt affects a company, and how one can identify the impact of this debt on the different financial statements. Finally, I'll highlight the ratios we can use to further determine whether a company is capable of managing its debt.
We will also take a look at the benefits and risks of companies taking on more debt. This is especially prevalent in low interest rate environments where companies typically take out more debt.
Debt is not always a bad thing, and if companies are able to leverage this debt to grow at a higher rate than what is owed from the debt, then this debt is beneficial and likely manageable. In fact, debt is almost a requirement for early-stage companies and can significantly improve a business's chance of success.
Therefore, it's crucial that investors know how to analyze a company's debt management, as companies with large amounts of debt and little cash flow are at risk for bankruptcy, which will ultimately minimize one's investment returns.
We will use Nike (NKE) to understand how to effectively analyze company debt. Its stock price performance is shown in the chart below:
The most popular type of debt is when a company takes out a bond, or when they issue a bond to the public. Therefore, when it comes to debt, I'll primarily focus on bonds.
Bonds affect all three primary financial statements, so it's important that we look at these when analyzing debt.
First, let's look at the income statement, where we can see the impact of debt on profits, earnings per share (EPS), or price-to-earnings (P/E) ratios.
This is what Nike's income statement looks like, with interest expense outlined ("Interest expense (income), net"). Sometimes, this interest expense is not shown on the income statement, and when this is the case you should check the financial statement footnotes and it'll likely be there.
One thing to know here is that positive interest expense reduces income, while negative interest expense (in parentheses) increases income.
The question you should ask yourself after finding this interest expense number, is asking whether it's too much debt for Nike to handle. In Nike's case, they have $49 million in interest expense. Looking at Nike's income statement itself, I can be fairly confident that Nike can handle its debt burden.
Moreover, Nike is the largest seller of athletic footwear and apparel in the world, so you likely don't have to worry about Nike's ability to pay back its debt obligations. Regardless, it's still important that you know how to analyze a company's debt levels, in cases where you may be investing in smaller market cap companies.
So, how do we really know if a company's debt is manageable? For this, we can look at a number of things.
First, we can look at the income statement again. Now, we know that interest expense is included in the line item "Other (income) expense, net," as outlined below:
So, one good figure you can look at is operating income, or EBIT (operating income does not include non-operating income, non-operating expenses, or other income). For Nike's case, we can solve EBIT to be $4,850 million ($49 + $4,801), as outlined below:
Now, the question is whether Nike's interest expense of $49 million is too much. Given the size of their EBIT, even if they took their interest expenses and grew it by a factor of 10, they would still have a lot of EBIT room to cover this. However, if the EBIT was only $80 million or so for Nike, they would not have a lot of wiggle room here. In this case, I would see Nike as a more risky investment as the company would have too much debt.
So, if an economic recession, pullback in revenue, and pullback in operating profit or EBIT were to happen, this would likely expose this company to default risk, with an EBIT of $80 million and interest expense of $49 million.
Next, let's look at the cash flow statement. The cash flow statement is divided into three different sections.
Cash flow from financing, or the third section, is where we are going to focus our attention.
If Nike were to issue $50 million in bonds, it would appear in the financing activities section of the cash flow statement. In particular, it would appear right on this line item titled "proceeds from the issuance of term debt," or in Nike's case, "net proceeds from long-term debt issuance:"
Now, if they paid off debt instead, then it would appear on the line item below it, called "repayments of term debt," or in Nike's case, "long-term debt payments, including current portion:"
Understanding these different line items from just debt is a good thing to pay attention to as an investor.
We should also check Nike's cash flow statement to calculate its free cash flow, as it's an important measure that demonstrates how efficient a company is at generating cash. It's also important to remember that in lower interest rate environments, you will typically see higher free cash flow figures.
A rough estimate of free cash flow ("cash generated by operating activities" or "cash provided by operations") is calculated by taking the cash flow from operations and subtracting capital expenditures ("payments for acquisitions of property, plant and equipment" or "additions to property, plant and equipment"). Companies usually refer to plant, property and equipment as capital expenditures.
We can come up with a rough estimate of free cash flow by subtracting this $1,119 million from the $5,903 to get $4,784 million in free cash flow. When we compare this to their interest expense of $49 million, Nike has more than enough room to cover this interest expense.
The balance sheet is broken up into three sections: Assets, Liabilities, and Shareholders' Equity.
Often times, investors confuse liabilities and debt. Liabilities are a representation of what a company owes. This is divided into current liabilities and non-current liabilities.
Current liabilities are items owed by the company within the next 12 months. So, if interest has been accrued but not been paid yet, it would appear here. Otherwise, it would appear under "current assets" on the balance sheet as a prepaid item ("prepaid expenses and other current assets" for Nike). Anything beyond this 12 months is considered non-current liabilities.
If we were to look for debt, what we should actually look for is a line item called "current portion of long-term debt," "long-term debt," and/or "term debt" that falls into both the current liabilities and non-current liabilities sections:
The "current position of long-term debt" and "long-term debt" numbers together are the debt that Nike owes from the bonds they've issued. In other words, if you add up the current and long-term debt for 2019, you will get the total debt at $3,470 million.
So, if Nike were to issue $50 million in new bonds, this $50 million would show up under the non-current liabilities section for long-term debt. However, because they sold $50 million in debt, Nike would also receive $50 million in cash which would show up under assets for the line item "cash and cash equivalents." This would also balance the two sides of the balance sheet as both assets and liabilities moved in the same manner.
Outlined below are the two main things you want to look for in the balance sheet when analyzing a company's ability to pay back its current debts:
Under current liabilities, which are owed in the next 12 months, we can see that it's only $6 million for debt. We also know that Nike's interest expense is $49 million. This shows us that most of their bonds will likely mature after 12 months, and may be why the $6 million in current debt is so much lower than the interest expense.
Regardless, we should still see if Nike has enough cash to cover any maturing bonds within 12 months. As we can see, Nike has $4,466 in "cash and (cash) equivalents," which is more than enough to cover any short-term bonds maturing.
Moreover, if this cash figure happened to not be as big, another thing we could check is the free cash flow number we calculated before at $4,784 million. In other words, we should ask ourselves whether this free cash flow number is large enough to cover the current debt due in the next 12 months, which it is for Nike. Therefore, Nike could instead use the cash for acquisitions or new technology.
After looking through the three financial statements, you can use the four debt ratios listed below to confirm or deny any of the findings you make, or to give you a better understanding of how well a company is able to manage its debt. These ratios should be used together with your financial statement and company analysis to evaluate a company's financial well-being, and never just by themselves!
You can find company ratios and compare them to the industry averages on ReadyRatios for free.
The current ratio is a liquidity ratio that will give you an idea of how well a company is able to pay back its short-term obligations, or those due within 12 months.
Current ratio = Current assets / Current liabilities
The higher the current ratio, the better, as it indicates that a company is more capable of paying its creditor back.
So, you should find out the current ratio for the company you're interested in and compare this to the industry average. If this current ratio is in line with the industry average, or if it's higher, then this is a good sign as the company is more likely to pay the creditor back.
However, if it's lower than the industry average, then the company may be at a higher risk of bankruptcy. This may also be a sign of a poor management team.
The debt ratio is a financial ratio that tells investors the proportion of a company's assets that are financed by company debt.
Debt ratio = Total debt / Total assets
In this case, a higher ratio is actually worse because it illustrates that the company is putting itself at risk of default with its debt if interest rates were to rise suddenly.
You should also follow these debt ratio measures:
These debt ratios also vary depending on industry, so you should compare the debt ratio figure you come up with to the industry average as well.
The interest coverage ratio (times interest earned ratio), is a debt and profitability ratio that gives investors a good idea of how easily a company can pay interest on its debts.
Interest coverage ratio = EBIT / Interest expense
The higher the interest coverage ratio, the better. This is because the ratio measures the number of times a company can cover its current interest payments with its current earnings.
On the other hand, if a company's interest coverage ratio is lower than the industry average, then it will be burdened by any debt expenses. Often times, if this ratio is below 1.5, the company will struggle to meet its interest expenses.
The debt-to-equity (D/E) ratio reflects the ability of shareholders' equity to cover all debts if a business downturn were to occur. It identifies companies that are higher leveraged, and therefore, higher risk.
D/E ratio = Total liabilities / Total shareholders' equity
The higher the ratio, the worse. This ratio is also difficult to be compared to the industry average, as ideal amounts of debt for companies will vary.
As an investor, all of the things mentioned in this article are essential things to keep watch of. You should also not completely disregard all other line items on the balance sheet as I did in this article, as it's important to look at each one of them and see if you identify any unusual numbers.
A final thing to keep in mind when analyzing company debt, is that companies often issue a new bond after paying off an old bond. In other words, companies simply put off paying bonds. For example, let's say that a company issued a bond 10 years prior with an interest rate of 6%. Today, the company may issue that very same bond at the same amount, but this time the interest rate would be 2%. If this were to happen, then the company would end up with a lower interest expense every year.
In short, you should be aware of possible causes of higher profits and higher free cash flow figures when analyzing a company's debt management. Furthermore, if the Federal Reserve continues to drop interest rates, companies can continue putting off paying off bonds without any real problems.
Regardless, it's important that companies do not overload on debt because then it may become very difficult for them to manage their business once interest rates begin increasing. Fortunately, we can use the 10-K annual reports to tell us how much debt is due soon, along with the financial statements and debt ratios covered in this article to determine a company's debt management abilities.
Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.