When you invest in a company, you need to look at many different financial records to determine if it is worth investing in. However, if after completing all the research, you invest in a company and then it decides to borrow money, what does this mean to you? Here, we see how you can assess whether debt will affect your investment.
How does corporate debt work?
Before we begin, we need to discuss the different types of debt that the company can assume. Companies can borrow money in two main ways:
- Through the issuance of fixed income (debt) securities such as bonds, bills, bills and corporate bills
- Through a loan at a bank or lending institution
Fixed income securities
The debt securities issued by the company are purchased by investors. When you buy any type of fixed income securities, you are essentially borrowing money from a company or government. When issuing these securities, the company must pay an underwriting fee. However, debt securities allow companies to raise more funds and have longer periods than loans usually allow.
Borrowing from a private entity means going to a bank to obtain a loan or line of credit. Companies usually have open credit lines from which they can withdraw to meet cash needs for daily activities. Loans the company borrows from institutions can be used to pay company salaries, purchase inventory and new equipment, or keep it as a safety net. In most cases, loans need to be repaid in a shorter period of time than most fixed-income securities.
What to look for
Investors should look for something obvious when deciding whether to continue investing in a company that is taking on new debt. Here are some questions to ask yourself:
How much debt does the company currently have?
If a company has no debt at all, then taking on some debt may be beneficial because it gives the company more opportunities to reinvest resources into its operations. However, if the company in question already has a large amount of debt, you may want to think twice. Generally speaking, too much debt is a bad thing for the company and shareholders, because it inhibits the company’s ability to generate cash surplus. In addition, high debt levels may have a negative impact on common stock shareholders, who are the last to ask for a return from a bankrupt company.
What kind of debt does the company assume?
The maturity dates of loans issued by companies and fixed-income securities are very different. Some loans must be repaid within a few days of issuance, while others do not need to be repaid within a few years. Generally, debt securities issued to the public (investors) have longer maturities than loans provided by private institutions (banks). It may be more difficult for companies to repay large amounts of short-term loans, but long-term fixed-income securities with high interest rates may not be easy for the company. Try to determine whether the maturity and interest rate of the debt are suitable for financing the project that the company hopes to undertake.
What is the debt for?
Is the debt to repay or refinance old debt, or is it used for new projects that have the potential to increase revenue? Generally, you should think twice before buying stocks in companies that have repeatedly refinanced existing debt, which indicates that you cannot meet your financial obligations. A company that must continue to refinance may do so because its expenditure exceeds its income (expenditure exceeds income), which is clearly detrimental to investors. However, one thing to note is that it is a good idea for a company to refinance its debt to lower interest rates. However, this kind of refinancing aimed at reducing the debt burden should not affect the debt burden, nor should it be considered new debt.
Can the company bear the debt?
Most companies determine their ideas before investing money in them; however, not all companies can successfully put these ideas into practice. It is important that you determine whether the company can still pay in the event of trouble or project failure. You should check whether the company’s cash flow is sufficient to meet its debt obligations. And to ensure that the company’s prospects are diversified.
Is it possible to enforce special regulations for immediate recycling?
When looking at the company’s debts, check to see if there are any loan terms that may be detrimental to the company after the terms become effective. For example, some banks require a minimum level of financial ratios, so if any ratio specified by the company falls below a predetermined level, the bank has the right to recover (or demand repayment) the loan. Unexpectedly forced to repay the loan will magnify any problems within the company and sometimes even force its liquidation.
How does the company’s new debt compare to its industry?
Many different fundamental analysis ratios can help you in this process. The following ratios are a good way to compare companies in the same industry:
- Quick ratio (acid test): This ratio tells investors the company’s ability to repay all short-term debt without selling any inventory.
- Current ratio: This ratio represents the number of short-term assets and short-term liabilities. Compared with liabilities, the larger the short-term assets, the better the company’s ability to repay short-term debts.
- Debt-to-equity ratio: A measure of a company’s financial leverage by dividing long-term debt by shareholders’ equity. It indicates the proportion of equity and debt that the company uses to finance its assets.
A company that increases its debt burden should have a plan to repay the debt. When you have to assess a company’s debt, try to make sure that the company understands how debt affects investors, how debt is repaid, and how long it takes to repay the debt.