You must have heard investors explain how they made hefty returns on stocks they bought when the share price was low and sold when it rose significantly. However, it is also common to hear investors losing money on stock investments due to their prices falling significantly. Volatility is common in the stock market, and stock prices increase and decrease regularly. However, if the stock in which you have invested has a negative fundamental factor, such as a low debt management ability, the investment can lead to long-term losses. Investors who successfully invest in stocks evaluate stocks based on numerous fundamental factors, including the company’s debt management ability.
 

If you are a stock market investor, it is crucial to know how to analyse a company’s debt management ability for effective stock evaluation. This blog will help you understand the process of analysing a company’s debt management ability.

• A company's debt management ability is its capacity to meet debt obligations without compromising operations.
• Investors analyse a company’s debt management ability when executing fundamental analysis.
• It helps investors to pick stocks that have lower financial risk.

A company's debt management ability refers to its capacity to manage and repay its debts while maintaining financial stability effectively. Investors assess a company's debt management ability by analysing various ratios, such as debt-to-equity ratio, interest coverage ratio, and cash flow, to ensure it can meet interest payments and principal repayments without jeopardising operations or profitability. A company with good debt management ability should not take excessive debt and have enough cash flow to cover a majority of its obligations. 

Here are the financial ratios you must analyse to understand a company’s debt management ability:

Interest coverage ratio

The interest coverage ratio measures a company’s ability to cover its interest payments with the earnings it has made. A company with a higher interest coverage ratio is more likely to cover interest payments with less risk of default. The formula is - EBIT (earnings before interest and taxes) / Interest expense.

Fixed charge coverage

The fixed charge coverage ratio measures a company’s ability to cover its fixed financial obligations, such as interest payments, rent payments or lease payments. Analysing the fixed charge coverage can allow you to understand the company's cash flow and risk management capability. The formula is - (EBIT+fixed charges before tax)/ (Interest expense+ fixed charges before tax).

Debt ratio

The debt ratio measures the total percentage value of a company’s assets financed through taking debt. A higher ratio indicates more risk as a larger portion of assets is financed through debt. The formula is - Total debt / Total assets.

Debt-to-equity ratio

The debt-to-equity ratio measures the proportion of a company’s debt to its equity. A higher D/E ratio indicates that the company relies heavily on debt and has a higher financial risk. If the ratio is low, the company is less likely to default on the loan. The formula is Total liabilities / Stockholder’s equity.

Debt to tangible net worth ratio

The debt-to-tangible net worth ratio calculates a company's leverage by comparing its total debt to its tangible net worth. A higher ratio indicates a higher financial risk, while a lower ratio indicates a lower financial risk. The formula is - Total liabilities / (Stockholder’s equity–intangible assets).

Operating cash flows to total debt ratio

The ratio measures a company's ability to cover its debt obligations using its operating cash flow. A higher ratio indicates a company’s ability to generate adequate cash flow, while a lower ratio indicates that the company may struggle to cover its debt obligations. The formula is - Operating cash flows / Total debt.

Debt management ratios provide insights into the debt management capability of a company. If the ratios, such as debt-to-equity or debt ratios, are high, the company may have high borrowings and financial risk. On the other hand, if ratios such as debt service coverage ratio or interest coverage ratio are low, the company has strong debt management ability, indicating lower default risk.

If a company takes debt continuously and increases its borrowings, it affects its intrinsic value. If the company is using borrowed funds to increase its revenue at a rate higher than the debt’s interest rate, it can maintain its intrinsic value, or it may decrease.

It is important to know how to analyse a company’s debt management ability to ensure you are investing in a company with lower financial risk and can meet all its debt obligations. Now that you know the process of analysing a company’s debt management ability, you can make informed investing decisions.