Debt is a normal part of business finance. Companies may borrow money to purchase equipment, acquire other businesses, expand operations, fund projects, or meet other financial needs.
Debt is therefore not automatically good or bad. The more useful question is whether the amount and structure of a company's obligations appear manageable relative to its assets, earnings, cash flow, and ability to meet those obligations.
Examining debt together with liquidity and balance-sheet strength can provide a more complete picture of a company's financial condition.
1. What Is Debt?
Debt represents money a company has borrowed and is generally obligated to repay according to specified terms.
Common forms can include bank loans, bonds, notes, credit facilities, and other borrowings.
Debt normally requires repayment of principal and may require periodic interest payments. These obligations can place demands on a company's future cash flow.
2. Short-Term and Long-Term Debt
Debt is commonly separated according to when it is due.
Short-term debt generally includes borrowings or portions of borrowings expected to be repaid within approximately one year.
Long-term debt generally includes obligations due more than one year in the future.
Investors may want to examine both the total amount of debt and when significant obligations mature. A company facing large near-term repayments may have different financial pressures from one whose debt matures over many years.
3. Debt Is Not the Same as Total Liabilities
Debt and liabilities are related concepts, but they are not identical.
Total liabilities can include debt as well as accounts payable, accrued expenses, lease obligations, taxes payable, deferred liabilities, and other obligations.
This distinction is important when interpreting financial ratios. A calculation using total liabilities is measuring something different from one using interest-bearing debt.
4. Why Companies Use Debt
Companies may use borrowed capital for many purposes, including:
- Expanding operations
- Purchasing equipment or property
- Acquiring another company
- Funding research or development
- Refinancing existing obligations
- Repurchasing shares
- Supporting working-capital needs
Borrowing can allow a company to make investments without issuing additional shares, but it also creates contractual obligations that generally must be serviced regardless of business conditions.
5. Interest Expense
Borrowed money generally has a cost. Interest expense represents the cost associated with debt financing.
Higher debt levels or higher interest rates can increase interest expense and reduce the amount of earnings available after financing costs.
When researching debt, investors may therefore want to consider not only how much a company owes but also the cost of that debt.
6. Debt-to-Equity Ratio
One commonly used measure of financial leverage is the debt-to-equity ratio.
A simplified calculation is:
Debt-to-Equity Ratio = Total Debt ÷ Shareholders' Equity
This ratio compares borrowed capital with reported shareholders' equity.
A higher ratio generally indicates greater use of debt relative to equity. However, appropriate leverage varies considerably by industry and business model.
Debt-to-equity can also become difficult to interpret when shareholders' equity is unusually small or negative.
7. Liabilities-to-Assets
Another way to examine financial obligations is to compare total liabilities with total assets:
Liabilities-to-Assets Ratio = Total Liabilities ÷ Total Assets
This provides perspective on how much of the company's reported asset base is offset by reported liabilities.
As with other ratios, the result should be interpreted together with the composition and quality of the company's assets and liabilities.
8. Liquidity
Liquidity refers to a company's ability to meet financial obligations as they become due, particularly shorter-term obligations.
Cash and other current assets can provide resources for paying suppliers, employees, lenders, taxes, and other obligations.
A profitable company can still encounter financial difficulty if it lacks sufficient liquidity when payments become due.
This is why profitability and liquidity should be examined separately as well as together.
9. Working Capital
Working capital provides one basic measure of short-term financial resources:
Working Capital = Current Assets − Current Liabilities
Positive working capital generally means reported current assets exceed reported current liabilities.
Negative working capital means current liabilities exceed current assets.
However, working-capital requirements vary significantly among businesses. Some companies can operate effectively with relatively low or even negative working capital because of the timing of customer receipts, inventory turnover, supplier payments, or other characteristics of their business model.
10. Current Ratio
The current ratio compares current assets with current liabilities:
Current Ratio = Current Assets ÷ Current Liabilities
A ratio above 1 indicates that reported current assets exceed reported current liabilities.
The current ratio can provide useful context about short-term financial resources, but it does not measure the quality or immediate availability of every current asset.
Inventory, for example, may be less liquid than cash.
11. Interest Coverage
Interest coverage attempts to measure the relationship between operating earnings and interest expense.
One commonly used calculation is:
Interest Coverage Ratio = EBIT ÷ Interest Expense
EBIT means Earnings Before Interest and Taxes.
A higher interest-coverage ratio generally indicates that operating earnings exceed interest expense by a wider margin.
A low or declining ratio may deserve additional investigation because it can indicate that interest costs are consuming a larger portion of operating earnings.
Exact definitions may vary among data providers, so investors should understand how a particular ratio has been calculated.
12. Debt and Cash Flow
Debt ultimately has to be serviced with cash.
For that reason, investors may want to compare debt obligations with operating cash flow and free cash flow.
A company with substantial debt but strong and consistent cash generation may have a different financial profile from a company with similar debt and weak or highly unpredictable cash generation.
Cash flow can therefore provide important context when evaluating leverage.
13. Debt and Return on Equity
Debt can influence profitability ratios such as return on equity.
Because ROE compares net income with shareholders' equity, using more debt financing and less equity financing can sometimes increase reported ROE.
This means a high ROE should not automatically be interpreted as evidence of superior financial strength.
Investors may want to examine ROE together with debt-to-equity, balance-sheet strength, ROIC, and cash flow.
14. Debt Maturities
The timing of debt repayment can matter almost as much as the total amount owed.
Companies often disclose schedules showing when significant debt obligations mature.
If a large amount of debt is approaching maturity, the company may need to repay it using available cash, refinance it, issue new securities, sell assets, or use another source of capital.
Refinancing conditions can change over time, particularly when interest rates or credit conditions change.
15. Assets Versus Liabilities
One straightforward balance-sheet comparison is total assets versus total liabilities.
The relationship can be expressed as:
Shareholders' Equity = Total Assets − Total Liabilities
A history in which total assets consistently exceed total liabilities provides one measure of balance-sheet strength, although it does not eliminate financial risk.
The composition of those assets and liabilities still matters. Cash, inventory, property, goodwill, debt, leases, and other items have different financial characteristics.
16. Why Several Years Matter
Debt should generally be examined over time rather than at only one date.
A multi-year history can help reveal whether:
- Debt is increasing or declining
- Cash balances are strengthening or weakening
- Assets are growing faster or slower than liabilities
- Interest expense is becoming more significant
- Shareholders' equity is increasing or decreasing
- Cash generation appears sufficient relative to financial obligations
Trends can provide context that a single balance sheet may not reveal.
17. Warning Signs Worth Researching
Debt and financial-strength observations that may deserve additional investigation include:
- Debt increasing substantially faster than earnings or cash flow
- Persistent negative shareholders' equity
- Liabilities growing faster than assets over an extended period
- Declining cash while short-term obligations increase
- Large amounts of debt approaching maturity
- Increasing interest expense combined with weakening operating income
- Weak or declining interest coverage
- Dependence on repeated borrowing to support normal operations
None of these observations automatically establishes that a company is financially unsound. They identify areas that may warrant deeper research.
How Stock Sage Uses Balance-Sheet Strength
Financial strength is an important part of Stock Sage's fundamental qualification process.
Stock Sage requires:
Total Assets > Total Liabilities in each of the previous 5 years.
This rule is intended to focus further research on companies that have maintained more reported assets than reported liabilities throughout the five-year period examined.
Stock Sage combines this requirement with its earnings-history requirement:
Positive EPS in at least 4 of the previous 5 years.
Passing these requirements does not establish that a company is debt-free, low-risk, undervalued, or appropriate for a particular investor.
Instead, the requirements form part of a screening process designed to identify companies with a demonstrated history of profitability and balance-sheet strength for additional research.
Users can then consider debt, cash flow, profitability, valuation, price history, and other available financial information when conducting that research.