To most value investors, debt is one of the first things they look at when analysing a company.  Since value investing, almost by definition, involves buying unpopular stocks, there is often some kind of bad news surrounding the company which will only be made worse by high levels of debt.

The problem with debt

Debt, in itself, is not a bad thing and is vital to almost every company in some way or other.  Some debts are short term and interest free, such as credit from suppliers, while other debts are longer term and do incur interest.  In most cases it is the interest bearing debts that are the danger, although in some cases a sudden reduction of incoming cash can cause a cash flow crisis where suppliers cannot be paid.

Debt and the turnaround situation

I used to invest in small and struggling turnaround situations and for these companies debt was a major worry.  Although these stocks can often be picked up at 'bargain' prices and sold for big profits at a later date, the risks posed by debt are substantial. For small and struggling companies the current and quick ratios are a good place to start. 

The current ratio is the ratio of current assets to current liabilities.  There are no hard and fast rules but many value investors prefer a ratio of 2 or more in order to ensure sufficient short term liquidity.  This can be a rather limiting rule that is only really suitable for turnarounds rather than solid, healthy companies.

The quick ratio is the ratio of quick assets – those which can be turned to cash within 30 days or so – to current liabilities.  An alternative to working out the true quick assets is to remove inventory from current assets and use that figure.  The idea is that often inventory cannot be turned in to cash quickly and would be of no use in generating cash during a cash crisis.  A quick ratio of more than 1 is enough to keep most value investors happy although again, this can be limiting if applied to healthy companies.

Debt and the wonderful company

I no longer invest in small and struggling companies and instead much prefer the advice of Warren Buffett who said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price".  With…

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