When it comes to the investing game, few things are black and white. There is an exception to almost every rule out there, so it is difficult to give one-size-fits-all recommendations. In some cases, however, a rule is so widely applicable that it makes sense to overlook the exceptions. One of these cases is avoiding companies with excessive levels of debt.
Almost all companies rely on debt at some point in their lives to either fund expansion or cover short-term capital shortfalls. It would be difficult to imagine a world where businesses were not able to borrow at all. But at a certain point, a debt load can become too great, spelling serious trouble for shareholders.
How is the capital being deployed?
How do you spot bad debt management? To answer this question, we must first ask ourselves why the business in question is turning to the capital markets in the first place. If management is using debt to fund expansion, then we must look at whether that capital is being intelligently deployed. Obviously, static revenues would be a major warning sign in this case. But there are other, less clear signals that should also sound the alarm bells. Static or declining earnings and margins are bad news, even in the context of rising revenues.
A prime example of this is a company like Tesla (TSLA, Financial). It took a while for analysts and investors to catch on to the fact that expanding revenues do not really mean much when losses are also expanding. It was arguably this realisation that was behind the recent IPO underperformance for both Uber (UBER, Financial) and Lyft (LYFT, Financial), when investors finally realized that growing revenues are not a long-term fix for cash-burning businesses.
What to do?
There are a number of metrics that investors can consult when they are determining whether a company has excessive debt. Debt-to-equity is a simple ratio that shows whether a business’s assets are financed primarily by debt (a higher number) or equity (a lower number).
On its own, debt-to-equity does not tell you much about whether the debt is being managed correctly. For a measure of this, look at free cash flow to debt. This metric tells investors whether the company is generating sufficient cash from operations to cover debt and interest expenses. If it is, then a debt load is unlikely to be too onerous, at least in the short to medium term.
Summary
In short, debt can kill your portfolio performance if you invest in businesses that are struggling to meet their obligations to creditors. Make sure management is deploying capital effectively and that the company is generating enough cash to pay off lenders. Otherwise, stay clear of these investments.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks: The Importance of Second-Level Thinking
- How to Win at Income Investing
- How to Invest in Biotech: Know Your Catalysts
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