As companies announce results, investors have an opportunity to identify quality stocks. This results season, as analysts crunch numbers, a deeper understanding about a company’s profile can help investors. Companies may borrow funds to run day-to-day operations or for business expansion. Relying on some amount of debt is healthy for a company’s growth. However, high debt can pull down stocks of even a high profit earning company. This is because interest paid on debt can eat into the company’s profits.
While looking for quality stocks, investors generally focus on profits. Indebtedness of a company is an important aspect that determines its operations and growth. Therefore, investors should have a close eye on corporate debt.
Related read: 6 things to know about corporate debt borrowing
While analysing a company’s debt profile, the following ratios can be considered:
By having a deeper look into the debt ratio, you can know whether the company is at risk of defaulting on its debt. It can be found in a company’s balance sheet. You can calculate it by dividing a company’s total assets by total liabilities. Debt ratio helps an investor to know the percentage of the company’s assets that are funded by incurring debt. Investors should prefer companies with low debt ratio over companies with high debt ratio.
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This ratio shows the relative proportion of debt and shareholders’ equity used to fund a company’s assets. A higher debt-to-equity ratio indicates that the company is aggressively financing its growth, with the help of external fund. Now, you might be thinking, what can be considered as a high debt-to-equity ratio. It differs for different companies. There is no single benchmark beyond which the debt-to-equity ratio will be considered high. For example, for the financial industry, leveraging is the natural way of doing business. This is because, these financial institutions, borrow money to lend money, which automatically raises their debt-to-equity ratio.
For other companies also, you should have a look at their historical data on debt-to-equity to identify red flags.
Related read: 4 financial ratios to analyze stocks
Let’s suppose the company you have invested in is to default on its debt. If the company has to sell off all its assets in order to payback debt, only tangible assets can be sold. Tangible assets are physical assets like equipment, building inventories and investments etc.
It this ratio is greater than 1, the company’s debt is more than the total selling value of its tangible assets. A less than 1 ratio means, if the company liquidates all its tangible assets to pay off debt, it will still have something left over.
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