Company Valuation Methods - Debt Evaluation Formulas

When evaluating the possibility of purchasing a particular stock, debt of the company may represent a factor that can influence your decision.

No exact answer can be given as to whether you should purchase stock of a company that has heavy debt. Additionally, some industries in their nature require companies to incur higher levels of debt than others.

For example the utilities sector requires the borrowing of larger amounts of money in order to finance major projects, such as the construction of new power plants. Since these projects are of a long-term character, the utilities company will lack revenue for the years to come and will incur high levels of debt.

Nevertheless, the construction of a power plant represents an investment, which when the debt is covered generates high levels of cash.

On the other hand, a company from another sector that has incurred heavy debt may not represent a good investment choice. However, you should examine the reasons for the big debt, since it may be caused by the financing of a company expansion or acquisition.

Debt to Equity Ratio

One of the tools you can use to determine whether a certain company is incurring heavy debt is the Debt to Equity Ratio. This ratio provides information on the portion of debt that is used for the purposes of financing the assets of the company.

In order to calculate the Debt to Equity Ratio of a particular company you should apply the following formula:

Debt to Equity = Total Liabilities / Shareholder Equity

How do we interpret the results? If the result of the ratio is equal to 1 or more, then the company implements more debt than equity in order to provide financing of the assets it uses. If the interest rates are increasing, a company that experiences a higher ratio relative to that of the companies from the same sector may signal that the company is at risk.

Interest Coverage Ratio

The money the company has borrowed doesn't come for free. This means that the company has to pay interest on the debt.

In order to determine whether a company is capable of covering the interest it has to pay on its debt, you can apply the following formula:

Interest Coverage = EBITDA / Interest Expense

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. This value represents the operating performance that a company has. This performance is before any accounting conventions are made and before any non-operational charges are deducted.

The Interest Coverage ratio provides you with information on the ability of the company to cover its interest expenses. It gives you an idea on whether the company produces enough cash to cover the interest.

The desirable result of the ratio is 1.5 or more. An amount lower than this signifies that the company encounters difficulties in covering its debt interest expenditures.

Finally, you should not view debt as something evil. On the contrary, if used in accordance to the company's plans it will provide the business to grow to its potential. On the other hand, if the money is not used properly, the company may suffer decline in its performance.

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