- Investment strategies
- Why invest in the stock market?
- Buy and hold or technical analysis? Why you need an investment plan
- Value investing and short selling in volatile markets
- Using technical analysis to support value investing
- Investing in the unexpected
- Franking credits, explained
- What is dividend stripping and is it a sensible strategy?
- Investing in quality IPOs
- How to invest in stocks that benefit from a moving Australian dollar
- Reasons to avoid bonds when interest rates are low
- How value investors use Skaffold
- Quality, growth and value = a winning strategy
- Know your investor type and boost your performance
- Technical + fundamental analysis = better buy and sell decisions
- Fundamental investing
- Value investing and the price earnings ratio
- Intrinsic valuation models and methodology
- Value investments or value traps?
- How to find value stocks in a bull market
- Find value investments in expanding markets
- Why capital raisings struggle to add investment value
- How to value an insurance company
- Top stocks
- 5 qualities of top stocks
- How to find stocks with a competitive advantage
- Why return on equity is the best measure of business performance
- Using cash flow to find value investments
- Finding high quality dividend stocks
- Debt is not always a dirty word
- Why Skaffold share investment software makes sense
- Using economic factors to uncover the best investment options
- How do experts find top stocks to invest in?
- Investing in global stocks
- How to invest in international shares on global stock markets
- Benefits of investing in international shares
Debt is not always a dirty word
Some businesses effectively utilise debt to accelerate growth.
Despite popular belief, debt is by no means a dirty word when it comes to running a business. Indeed some businesses effectively utilise debt to accelerate growth.
But if the managers of your businesses don’t effectively manage the level of borrowings, they can easily undermine the overall value of your share investment portfolio.
Global stock markets are littered with stocks that have imploded under the strain of too much debt relative to their earnings. If the global financial crisis (GFC) has any positive legacy, it’s the way it forced companies to redefine the value of debt and what it means to carry too much on their balance sheets. Interestingly, while the management of ‘under-geared’ companies - with little to no debt – were once accused of running ‘lazy’ balance sheets, they’re now lauded for good financial management.
Smart investors focus on debt levels. Why? Because debt has to be repaid, and creditors will always recoup their losses before shareholders.
Value investors also avoid companies offering dividends that cannot be supported through cash generated by the business.
As crazy as it sounds, prior to the GFC some companies often borrowed the funds necessary to pay their dividend. Suffice to say none remain in business today.
In spite of lessons learnt, the ASX remains littered with many large-cap blue chip companies, with the size and brand familiarity to attract uninformed investors, that have large debt levels and poor cash flow (and continue to fund dividends with debt and/or capital raisings).
4 financials ratios to spot stocks with too much debt
Figuring out whether a company is self-funded or relies on external funding (a la debt) - after factoring in its operations, investments and financing - isn’t a simple exercise. Here are 4 key financial ratios you can use to understand if a business is self-funding and how it funds its dividends.
1. Net Debt to Equity ratio
Skaffold calculates annual net debt to equity ratios for every ASX-listed company, plus up to 2,000 of the world’s largest listed stocks.
The net debt to equity ratio captures the size of a company’s debt compared to its total shareholders equity, allowing for any cash in the bank. The ratio allows investors to pressure-test the potential impact of debt on the quality and sustainability of a company’s earnings and distributions.
By taking the net debt (debt less cash balance) and dividing it by the total shareholders equity, you arrive at a net debt to equity ratio. Skaffold prefers stocks to have a net debt to equity ratio well under 40%.
Admittedly, the better a company’s underlying cash flow, the greater it’s capacity for gearing its balance sheet. But assuming debt levels are modest - typically with net debt to equity under 30 per cent - companies with higher return on equity (ROE) should have higher levels of profitability.
2. Cash Interest Cover ratio
Value investors are attracted to stocks with sufficient earnings to adequately cover net interest expenses. Calculated by dividing operating cash flow by borrowing costs paid, the Cash Interest Cover ratio reveals how many times over a business can pay its interest bill with its cash flow. The higher the number the better!
Assuming a company can cover its net interest expenses a minimum of three times over, it will be able to continue servicing debt without overlooking its tax obligations and either distributing to shareholders via dividends or alternatively reinvesting in business growth.
There are no hard and fast rules about gearing, and what’s regarded as ‘acceptable’ interest cover will vary between companies and different industry sectors. As a case in point, capital intensive infrastructure stocks are typically more highly geared because of the very steady cash flows their assets can generate.
3. Skaffold’s patent-pending cash flow Funding Surplus/Gap
This ratio, unique to Skaffold stock research software, tells you instantly if a company is spending more money than it is earning.
A Funding Gap occurs when there’s insufficient cash to continue operating and the company is forced to take on debt or raise capital from shareholders. Try to steer clear of stocks in a Funding Gap.
If you don’t have a clear understanding of how the cash generated by a business has been utilised, and whether or not the company has required external funding to finance its activities, then find out before investing in it.
Skaffold’s Funding Surplus/Gap is arrived at by subtracting the capital expenditure, investments and dividends paid from the company’s cash flow generated from its operations. The greater a company’s funding surplus the more likely it is to avoid excessive borrowing, expand its business, pay dividends and withstand any economic headwinds.
4. Debt and return on equity
Companies able to produce rising profits without the need for debt or dilutive shareholder capital raisings are more attractive. They produce increasingly profitable returns on equity without increasing risk.
Skaffold’s Capital History screen lets you quickly assess profitability and determine if you’re comfortable with the level of risk. It shows a company’s relationship with its owners and lenders.