Debt of the company is the ratio of all liabilities of a company to all of its assets. Cleverly, this metric is called the debt ratio. This is a fairly simple metric that allows you to assess how risky it is to invest in a company. Let’s see how it works.
The story of Vasya and Petit
Suppose we have Vasya Pupkin and Petya Vasechkin. Vasya has a loan for 3 million rubles and property: a car worth 1.5 million rubles and an apartment worth 5 million rubles. In terms of Vasya’s balance sheet: total debt = 3 million; the total asset value is 6.5 million (1.5 million + 5 million). This means that Vasya’s debt ratio is 3 / 6.5 = 46%. Or in other words – Vasya’s share of debt in his assets is 46%.
Petya Vasechkin decided to go out to the fullest and collected loans for 10 million rubles. Petya does not have a car, but he has an apartment worth 7 million rubles. In this case, Vasechkin’s debt ratio is 142.8% (10 million / 7 million).
Now let’s imagine that something terrible happened and Petya and Vasya lost their jobs. In this case, in order to repay the debt of 3 million rubles, Vasya, for example, will need to sell the apartment. But Vasya will still have the car and part of the money from the sale of the apartment. As for Petya, his affairs are very bad. Even having sold an apartment (i.e., left completely without assets), he will not be able to fully pay off the debt and will be forced to look for other ways out of the situation.
When we analyze the balance sheet of a company, our analysis, in principle, is no different from the analysis of the history of Petit and Vasya. If a company has a high “debt load”, then this means that the risks of investing in the shares of such a company increase significantly. But the question arises – what is high or low “debt load”? In fact, it depends a lot on the industry.
The highest debt ratio is in the banking sector. It may be close to 100%, but the bank will function quite normally without experiencing problems. In all other sectors, debt ratios above 80% may already indicate increased risks and investing in shares of such companies is fraught with unpleasant consequences.
Debt ratio totals
- The debt ratio is calculated as the ratio of all the company’s liabilities to all assets;
- The higher the debt ratio, the worse;
- “Debt level” above 80% indicates significant risks when investing in the company’s shares;
- If the company belongs to the banking sector, then the “debt load” can be very high, and this is normal;
- All other things being equal, it is necessary to choose for investing stocks of companies whose debt ratio is the lowest.
In addition to the debt ratio, other similar ratios can be used in the analysis, for example:
- Absolute liquidity ratio = (cash + short-term investments) / current liabilities;
- Quick liquidity ratio = (cash + short-term financial investments + short-term receivables) / current liabilities;
- Current liquidity ratio = working capital / current liabilities