Investing in Companies with Debt

Investing in Companies with Debt

Companies with too much debt particularly long-term debt can suffer drastic affects from rising interest rates and significantly decrease cash flows. In a worst case scenario a company can be sent into bankruptcy,

Companies that have fixed rates of interest and obtain financing before they need it can skillful use debt. Debt can effectivelyu increase the return on equity in a company very leverage.

Leverage works like this. If you buy a share for $100 and pay cash and it pays a yearly dividend of $10, your rate of return is 10 per cent, that is 10 times 100 divided by $100. If however you borrow $50 at an interest rate of 5 per cent and use that to buy the share, you are only putting in $50 of your own money. Of course, you must pay interest on the loan of $2.50 (5 per cent of $50) and this comes out of the dividend that you receive. So you net $7.50 ($10 dividend less $2.50 interest). Your net return in percentage terms has now increased to 15 per cent (7.50 times 100 divided by 50).

Using leverage to invest in an asset that produces a return, whether it be shares, property, manufactured goods, or provision of services,  can therefore increase your rate of return and many businesses and investors do this. The higher the amount borrowed, the greater the return. The problem comes if and when the income from the producing asset falls, or reduces; in either case, you still have to pay the interest. Here leverage works in reverse. Further problems can arise where the lender has the power to increase the interest rate.

Debt tests

The Current Ratio of Liabilities to Current Assets of a company is very important in looking at the companies financial position. The higher the ratio the more comfortable one can be with the caveat that some businesses with too good a ratio hold too much surplus cash and that certain businesses require lower ratios than others because of protracted periods for customer payments.

Industrial Companies 2 to 1 ratio

Quick Ratio, a similar calculation but excluding inventory. Again, the size of the ratio will depend upon the business: companies with inventories that can readily be converted into cash probably do not need as high a ratio as those with longer-term inventories.

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