Borrowings – how do you know if a company is in serious trouble?
A profitable company is a great thing, but what if this profitability is being driven by debt? Down the line this is going to lead to serious problems.
To ensure we stay away from such companies we perform two tests:
Debt ratio test - The debt ratio test aims to calculate how many years it would take to wipe out all borrowings at current earning rates.
Debt ratio = total interest borrowings / 5 year average post tax profits
If we calculate a debt ratio greater than 5, the alarm bells have to start ringing. A company that has interest borrowings 5x as high as yearly profits is in a worrying position.
Long term debt ratio (%) - This test assesses borrowings as a proportion of shareholder equity. If we see that borrowings are more than 50% of company capital the firm really is in trouble.
long term debt ratio (%) = Total interest borrowings/ Total assets - total liabilities
These two tests should provide enough comfort around a company's debt position. Our free value investing guide contains more tests to keep your money safe when investing.
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