Three measures of debt
Debt to equityAll borrowings, short and long, ÷ equity. How much the company relies on lenders compared with shareholders.
Net debtBorrowings minus cash and cash equivalents. It is a common analytical formula, and its definition can vary between analysts. A company with big loans and as much cash is not in the same place as one without.
Interest coverageOperating profit ÷ annual interest. How many times profit covers the interest bill.
ExampleThe invented company Al Wadi Foods has short-term loans of 100 million and long-term loans of 150, a total of 250. Equity is 600, so debt to equity is 250 ÷ 600 = 0.42. It holds cash of 80, so net debt is 250 − 80 = 170. Operating profit is 150 against interest of 30: coverage of 5 times.
When does debt get heavy?
The same debt can feel light in one year and heavy in another. Interest is fairly fixed while profit moves. When profit falls, coverage drops fast. If operating profit falls below interest, the business no longer covers its interest from operations, and the company must pay from cash or borrow again.
Dashed line = annual interest of 30 million
A normal yearOperating profit 150
Coverage 150 ÷ 30 = 5×
A weak yearOperating profit 60
Coverage 60 ÷ 30 = 2×
A hard yearOperating profit 24
Coverage 24 ÷ 30 = 0.8×
Three questions about any company's debt
- When is it due?A large loan due this year differs from one spread over ten years. Check current versus non-current on the balance sheet.
- In what currency?A company earning in pounds with loans in another currency may see its debt grow in pounds if the exchange rate moves. The notes tell you.
- What does it fund?A loan for expansion that brings revenue differs from one covering expenses or dividends. The cash flow statement shows where the money went.
Watch outNo single "safe" debt figure fits every company. Banks, for example, run on liabilities by design, and utilities borrow heavily by nature. Compare with companies in the same sector, and with the same company over several years.
Work it out for a real company
Open any company's statements from the disclosure archive, compute net debt and interest coverage, and look in the notes for repayment dates.
Check yourself
1. Borrowings 400, cash 100. What is net debt?
400 − 100 = 300.
2. Operating profit 45, interest 50. What does that mean?
Coverage is 0.9 times, below one.
Summary
- Debt to equity and net debt measure size; coverage measures the ability to service it.
- Interest is fairly fixed while profit moves, so debt gets heavy fast in weak years.
- Ask when it is due, in what currency, what it funds, and compare within the sector.