Yong Chia Win May 2, 2017
When you buy a company’s shares, do you wish that the company has made as little loans as possible?
If your answer to the above question is “yes”, you might be a conservative investor. But in actual fact, when it comes to loans, we cannot always assume that “less is more”.
Two ways that companies raise capital
Companies need funds to operate and develop their businesses, and they typically raise funds through two ways: 1) Loans (from banks or by issuing bonds), and 2) Issuing shares.
Theoretically speaking, a company may have a better credit if it takes a smaller loan. Less interest is incurred too, and that can translate to more money issued to shareholders through dividends. On top of that, keeping the debt level low also reduces the risk of the company facing financial problems.
Analysing a company’s debt situation
We will not be able to gauge if a company has a high or low debt level just by looking at its amount of loans. In order to get a better idea of a company’s financial situation, we can look at the following two ratios:
1. Debt/equity ratio
The formula for calculating debt/equity ratio is simply total liabilities/shareholders’ equity, where total liabilities = non-current liabilities + current liabilities.
This ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
In his book, Fu Zu Zi You Ren 2 (which translates to He who is Financially Free), investment expert Dr Chan Yan Chong also pointed out that this ratio can tell us for every dollar of shares owned by the shareholder, how much of it actually belongs to the creditor.
A higher debt/equity ratio would mean that the company has a higher amount of loans relative to capital provided by shareholders. It is not so much of a problem if the company has sustainable profit to pay off interest. But if earnings and profits were unable to meet the borrowing cost, the company would likely land in a problematic financial situation.
For instance, if we look at Hong Kong-listed China Evergrande Group, which the Wall Street Journal referred to as the “world’s most indebted developer”, has a debt to equity ratio of 3.40 as of Dec 2016, according to gurufocus.com. If not including the revaluation gains on its invested properties, the company would not have made profits last year.
Even though the share price of China Evergrande Group rose sharply last month, there was no solid basis for its gains.
2. Debt Ratio
Debt ratio also referred to as debt-to-assets ratio, is calculated by dividing total debt by total assets. Generally speaking, if a company has a debt ratio of more than 50 percent, it has a high level of debt.
However, whether a debt ratio is considered high or low may vary widely across industries. According to Investopedia, a debt ratio of 30 percent may be too high for an industry with volatile cash flows, whereas a debt level of 40 percent may be easily manageable for a company in the utility sector, where cash flows are stable and higher debt ratios are the norm.
The debt ratio is also something that investors in Real Estate Investment Trusts (REITs) are concerned about, as the Monetary Authority of Singapore (MAS) imposed a 45 percent leverage limit on REITs.
Companies with fewer loans are not necessarily better for investors.
Why is that so?
Assuming that a company chooses to raise funds through issuing shares, each investor’s stake might be diluted. If the company’s business flourishes and its earnings growth are higher than interest rates, then debt financing is a more reasonable choice, which is also more beneficial to shareholders.
Also, in an environment where the inflation rate is high but interest rates are low, the actual cost of borrowing is lowered, and in this case, companies should consider borrowing money too.
When you buy a company’s shares, do you wish that the company has made as little loans as possible?
If your answer to the above question is “yes”, you might be a conservative investor. But in actual fact, when it comes to loans, we cannot always assume that “less is more”.
Two ways that companies raise capital
Companies need funds to operate and develop their businesses, and they typically raise funds through two ways: 1) Loans (from banks or by issuing bonds), and 2) Issuing shares.
Theoretically speaking, a company may have a better credit if it takes a smaller loan. Less interest is incurred too, and that can translate to more money issued to shareholders through dividends. On top of that, keeping the debt level low also reduces the risk of the company facing financial problems.
Analysing a company’s debt situation
We will not be able to gauge if a company has a high or low debt level just by looking at its amount of loans. In order to get a better idea of a company’s financial situation, we can look at the following two ratios:
1. Debt/equity ratio
The formula for calculating debt/equity ratio is simply total liabilities/shareholders’ equity, where total liabilities = non-current liabilities + current liabilities.
This ratio indicates how much debt a company is using to finance its assets relative to the amount of value represented in shareholders’ equity.
In his book, Fu Zu Zi You Ren 2 (which translates to He who is Financially Free), investment expert Dr Chan Yan Chong also pointed out that this ratio can tell us for every dollar of shares owned by the shareholder, how much of it actually belongs to the creditor.
A higher debt/equity ratio would mean that the company has a higher amount of loans relative to capital provided by shareholders. It is not so much of a problem if the company has sustainable profit to pay off interest. But if earnings and profits were unable to meet the borrowing cost, the company would likely land in a problematic financial situation.
For instance, if we look at Hong Kong-listed China Evergrande Group, which the Wall Street Journal referred to as the “world’s most indebted developer”, has a debt to equity ratio of 3.40 as of Dec 2016, according to gurufocus.com. If not including the revaluation gains on its invested properties, the company would not have made profits last year.
Even though the share price of China Evergrande Group rose sharply last month, there was no solid basis for its gains.
2. Debt Ratio
Debt ratio also referred to as debt-to-assets ratio, is calculated by dividing total debt by total assets. Generally speaking, if a company has a debt ratio of more than 50 percent, it has a high level of debt.
However, whether a debt ratio is considered high or low may vary widely across industries. According to Investopedia, a debt ratio of 30 percent may be too high for an industry with volatile cash flows, whereas a debt level of 40 percent may be easily manageable for a company in the utility sector, where cash flows are stable and higher debt ratios are the norm.
The debt ratio is also something that investors in Real Estate Investment Trusts (REITs) are concerned about, as the Monetary Authority of Singapore (MAS) imposed a 45 percent leverage limit on REITs.
Companies with fewer loans are not necessarily better for investors.
Why is that so?
Assuming that a company chooses to raise funds through issuing shares, each investor’s stake might be diluted. If the company’s business flourishes and its earnings growth are higher than interest rates, then debt financing is a more reasonable choice, which is also more beneficial to shareholders.
Also, in an environment where the inflation rate is high but interest rates are low, the actual cost of borrowing is lowered, and in this case, companies should consider borrowing money too.
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