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Learn to love company debt! Well, up to a point. I see leverage through debt as a brilliant way for companies to create wealth. Most successful businesses use leverage to their advantage. Learn to understand debt and you’ll love it too.

Utilities, pipelines, and telecoms are perfect examples of how leverage can be used to the shareholders’ advantage. They operate capital-intensive business models; waiting to finance projects from cash flow would take them years during which their competition could hurt their market position. Therefore, they use debt to build long-term assets they expect will generate cash for decades.

If leveraged companies manage their debt effectively and invest in value-creating projects, they might receive more cash flow than they need, and be able to increase their dividend accordingly. That was easier to do when the banks’ money was cheap, which is no longer the case.

While we can use debt to boost our assets, not all debt is good nor do all leverage operations end well. Ignoring debt ratios because they’re boring or “too complicated” could leave you holding companies with too much debt on their books. When interest paid becomes a burden, bad news often follows, including layoffs, margin squeezes, and eventually dividend cuts.

To manage your portfolio well, know the debt ratios of your holdings, and combine that knowledge with the dividend triangle analysis. You’ll likely avoid bad news and pick thriving companies that know how to use the bank’s money to promote good outcomes. See Detect Losers and Find Winners with The Dividend Triangle.
 

Debt Ratios and Financial Lingo

Since debt ratios and financial lingo don’t make a gripping read, I tried keeping the explanations simple. We’ll talk about two categories of financial ratios:  liquidity ratios and leverage ratios.
 

Liquidity ratios

Liquidity ratios tell you if a company can afford to keep doing business. They determine the company’s ability to pay off current debt obligations without raising external capital (e.g., issuing shares or getting into additional debt). It’s pretty much the same as looking at your bank account balance before going to the restaurant.

We’ll look at three liquidity ratios: the Current, Quick, and Cash ratios. The current ratio is the most lenient; it considers all current assets. The quick ratio considers accounts receivable (makes sense since it’s incoming money) but discards inventory value. The cash ratio is harsher, considering cash and cash equivalents, nothing else.
 

Current Ratio

Commonly used, the current ratio determines the financial strength of a company’s balance sheet. Does it have enough assets to get through the quarter? Comparing a company’s current assets with its current liabilities quickly shows if there’s a short-term problem. I used the current ratio often during the 2020 market crash, to make sure companies in my portfolio had sufficient assets to get through the lockdown.

Current Assets / Current Liabilities

Obviously, we want to see more assets than liabilities. If the ratio is below 1, the company might run into financial problems sooner rather than later. Conversely, you don’t want too many current assets either. A ratio significantly over 1 can indicate poor management of assets; the company has too much cash and isn’t using it to create value.
 

Quick Ratio

The quick ratio is of great use during challenging times. It tells you if the company has enough cash or cash equivalents to pay its bills “at the end of the month”. Just like looking at your bank account and emergency fund to know if you can pay your mortgage, car payment, taxes, and utility bills. Unlike the current ratio, the quick ratio formula discards inventory on hand; it’s easy to be too generous with the inventory book value when things are going badly.

(Current Assets – Inventory) / Current Liabilities

A quick ratio above 1 is good and shows the company has enough liquidity to fulfill its short-term obligations. Ideally, you want it above 1.5. With a ratio below 1, the company has to be quick in selling its inventory. If it doesn’t sell it off fast enough, it’ll have to dig into its line of credit.
 

Cash Ratio

The cash ratio is straightforward but restrictive. It shows if the company has enough cash on hand to cover short-term liabilities. However, it focuses too much on cash, ignoring other assets that can help in bad situations. In challenging times, you don’t only count what’s inside your wallet. You look to other resources you can use, assets you can sell, or people you can call to raise cash. The same applies to a business.

Cash and Short-Term Equivalents / Current Liabilities

A ratio below 1 shows potential short-term liquidity problems. If this happens, look at other ratios to understand where the money will come from in the coming months. If you can’t find more cash flow, the company might have to rely on debt to keep going.

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