Looking at financial health of a company using debt ratios

A company can fund its operations and growth by using equity and debts. There are some debt ratios available that investors and analysts use to do a simple check into the financial health of a company. I shall provide a simple discussion on a few debt ratios with their uses and any limitations.

Debts is part and parcel of a company's capital structure. It is uncommon to find a company totally without any form of debts. However, there exists highly profitable companies (though the minorities) that do not require debts funding but all funding for the operations and growth of the company can be provided for by its retained earnings. Such excellent companies also boast of consistent high amounts of free cashflows in their accounts. As such, they employ minimal or no debts in funding their operations and growth. It is important to know where a company stands in terms of its amount of debts. A company that employs high amount of debts may run the risk of not being able to pay its debts when due and thus result in possible risk of bankruptcy.

To ascertain whether a company is financially healthy and is not employing a high debt load and burden, debt ratios are commonly used. To understand the use of such debt ratios, we need to first look at the two types of liabilities a company can incur. These two types are operational and debt liabilities. Liabilities falling under operational type include accounts payable, taxes payable and any forms of operating expenses. Liabilities falling under debts nature include notes payable, and any forms of short-term borrowings and long term borrowings.

Debt-Equity Ratio

Debt-equity ratio compares the total liabilities to shareholders' equity of a company. It reveals how much leverage a company engages. There is no hard and fast rule to tell whether a company is excessively leveraged. However, if a company is consistently more significantly leveraged to its similar competition in an industry, it may be a potential red flag for the company.

In looking at debt-equity ratio, the lower the ratio the better the financial health of a company. A lower ratio means lower total liabilities compared to the equity of a company. In using this ratio, one is considering the total liabilities which include both operational and debts liabilities. So, this ratio provides only a general look into all liabilities carried by the company compared to its equity. It does not focus on only the debts portion alone but also include other operational liabilities as well.

Capitalisation ratio

Capitalisation ratio provides a look into the amount of debts carried in a company's capital structure.

As capitalisation ratio considers only the debts portion compared to the total capital structure (capital raised by lenders and shareholders), it provides a more meaningful look into the composition of a company's capital structure. A lower capitalisation ratio indicates better financial position for a company.

Interest coverage ratio

Interest coverage ratio measures how easily a company can pay its interests on outstanding debts.

An interest coverage ratio of at least 1.5 or more is preferred. A lower interest coverage ratio may suggest that a company is taking on a high amount of interest expenses from a high amount of debts. A high interest coverage ratio also means a company has the capacity to further take on larger amount of debts (e.g. for expansion and growth opportunities) when required.

Cashflow to debt ratio

Cashflow to debt ratio provides a comparison between the operating cashflow and the total debts of a company. The total debts of a company will include short-term borrowings, current portion of long term debts and non-current portion of long term debts. This ratio seeks to measure how much the cash generated from operations can cover all total debts of a company.

Sometimes, free cashflow can also be used to substitute operating cashflow in the calculation. This will provide a more stringent measurement of the ability of the free cashflow generated by a company to cover its total debts. A high cashflow to debt ratio is preferred as it suggests the ability for the cashflows of a company to cover its total debts.

Conclusion

Debt ratios generally provide a look into the amount of debts carried by a company and measures the ability of a company to carry its debts at a financially healthy level. Almost all companies will carry different amounts of debts. Companies in different industries may also carry very different amount of debts. One should compare similar companies in an industry when using such financial ratios as the capital structure of companies in different industries may differ widely. Nevertheless, debt ratios help an investor to check for any potential warning signs on the financial health of a company. When assessing a company, amount of debts carried is only one component to look at. To have a better assessment of a company, an investor should look at the company holistically in many aspects, not just its capital structure alone.

Towards financial independence

I recently went through another audio book, "Rich Dad, Poor Dad by Robert Kiyosaki". I managed to capture some salient financial planning concepts from this audio book. After learning from various sources (e.g. audio books and seminars - see my previous posts on financial planning), I found out that all financial planning concepts point to same thing, that is the goal of reaching financial independence. As such, all concepts on financial planning tie in with one another and there is no contradiction in concepts as all concepts help the person who practise these concepts to arrive at same goal of financial independence.

In this book "Rich Dad, Poor Dad", it explained the reason why most people do not reach financial freedom. This is because of simply one thing - their total monthly passive income do not exceed their total monthly expenses. Most people may know of this cold hard truth already, but how many know of ways in which one can arrive at financial freedom. In reaching financial freedom, it is not just the methods per say that one should practise but the one and most important thing is to have the correct attitude and mindset of financial freedom. Therefore, financial freedom all begins with the correct attitude and mindset of the individual.

According to the book, one can classify his/ her finances using an accounting language. This is not foreign to many trained investors who are adept at assessing financial statements of companies. Similar to the financial statements of a company, an individual's finances can also be classified into his income, expenses, assets, liabilities and cashflows. To arrive at financial freedom, one's cashflow must always be positive. I see an equivalence of this to the importance of having consistent positive cashflows for companies as well. A company that boast of consistent positive cashflows year after year has consistent profitable business model and has use for its cashflows in reinvesting in its business, other growth opportunities or providing dividends to its shareholders.

Is active income from a job a financially stable source of income?

Now, I shall discuss more based on what I learnt from the book on the different categories namely income, expenses, assets, liabilities and cashflows with regards to an individual's finances. Most people survive on paycheck to paycheck in order to have a recurring income. Once they stop working due to any reasons, their income stops as well. This is known as active income that comes only by working. When the person stops working, he becomes financially unstable since there is no more income and he still needs money for basic survival (e.g. food, clothing).

One cannot do without minimal survival needs (e.g. without food, one goes hungry and may lead to death.). Thus, the important question to ponder is whether a person is financially stable with a job afterall? By looking at the above proposition, it may seem not. If a person ceases to be working, his income also ceases. His whole financial state starts to crumble unless he has some emergency funds to tide him and his family over a period of time while he finds another job. Anyway, a person may still due to any possible reasons in his life cease to be working (e.g. due to illnesses, disability or old age), so active income is actually not a stable form of income afterall. If one don't work, sorry - no more income for him......I am not saying that working is a bad thing here. In fact, one should continue working and contributing to people around him. One does not live as a hermit and needs to coexist with other beings and work is an avenue for rich interaction between people. So, work is important. One should work hard and contribute to people around him. However, the reality is that many people do not just work for the meaning of working. People work because they need the renumeration behind the work. They need the paycheck and need it continuously all their life. How many can actually boast that they work only for the fun and enjoyment of working to contribute to peoples' lives?

Of course, there is nothing wrong with working for a living. It is decent to work for a living. The point I am raising here is the need to reexamine how one looks at active income. Active income is not a stable form of income. It is misleading to say that one is financially secure with a job. It is in fact not financially secure at all with a job. Break off the active income source (the income paying job) and there is no more income into a person's finances.

Income producing assets as financially stable sources of income

If active income is not the way to go to become financially stable, how does one gain stable income sources? He does it by passive income sources. Passive income sources are sources of income that do not require the individual's time and effort to produce the income. Such income are generated passively (e.g. rental from real estate, dividends and capital returns from stocks and other forms of investments, royalties from books, business income from businesses not requiring one's attention). According to the book, these types of passive income come from such income producing assets (e.g. real estate, stocks and other forms of investments, businesses). So, if active income is not financially stable at all, the financially stable sources of income would come from income producing assets. To be financially stable, one should thus seek to build up his income producing assets in his management of finances. This is also the way to make money work for oneself and not the other way whereby one works for money. One can see every dollar saved and invested into building income producing assets as accumulating more workers for oneself, so as to make money become one's worker (every dollar held in such income producing assets is like individual worker, so the more money held in such assets, the more workers one have working for himself).

I guess the above illustrations are not unknown to many people. The question is why many are still not able to save and invest in such assets to build their passive income sources. We have to examine the next category of expenses and liabilities.

Expenses and liabilities stem from desires not easy to grapple with

Not all people are alike. Everyone has his own desires and many of an individual's desires can be satisfied by his expenses and liabilities. Imagine the thrill of owning one's car or a condominium. All these big ticket items are a drain to one's finances. Any items that draws away income instead of producing income are considered as liabilities to an individual. Being tied down by monthly instalments for paying car loans and housing loans make such items as car and houses as liabilities instead of assets. Some may argue that houses are assets to an individual. According to the book, as long as the item is not generating any income at all, but instead drawing out income from oneself, it should be conservatively considered as liabilities on one's finances. So, the problem with not being able to reach financial freedom is because the average person keeps tying himself down with lots of liabilities and expenses (e.g. from all loans and incessant spending) and not being able to save and invest in owning income producing assets instead.

It all begins with the attitude

In conclusion, to reach financial freedom, one needs to have the correct attitude and mindset of looking at ways to save and invest to build sources of income producing assets (e.g. rental from real estate, dividends and capital returns from stocks and other forms of investments, royalties from books, business income from businesses not requiring one's attention). Do this and reduce on one's expenses and liabilities at same time. It is a matter of perservering and sooner or later, one will reach financial independence should his income producing assets be able to produce passive income enough to cover all his expenses and liabilities. By then, his monthly cashflows will become consistently positive without his effort in producing active income and he is thus financially free.

To reach this goal, it does not mean that all people should quit their paying jobs. Before one can own substantial income producing assets, he needs an income source from his job to fuel his investment in income producing assets. So, it is time to rethink carefully whether one is really financially stable with a paying job? Most people are caught by greed and fear and so keep to their jobs (fear of no income) and seek improvements in their jobs or keep changing jobs to better their active income source (greed of wanting to increase active income). However, all these may not be comparable to a more financially stable source of passive income from owning income producing assets (yes, the more of such assets the better).

A final word to clarify that I am not proposing that people should not work for a living. One should work diligently and there is nothing wrong with working hard for a living. Even if one is financially free, one should still work and contribute to other peoples' lives. It is a privilege to be able to contribute to other peoples' lives, be it using one's time or money.

A short excerpt of investment wisdom from Benjamin Graham

Benjamin Graham was the investor who during his time taught that investments should be approached by sound principles of analysis. He taught that it is possible to valuate investments to estimate their value by fundamental approach. Here, I include an excerpt from one of my readings of his writings from the book, "The Rediscovered Benjamin Graham, Selected Writings of the Wall Street Legend by Janet Lowe."

"Let me close with a few words of counsel from an 80-year-old-veteran of many a bull and many a bear market. Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that's the row you should hoe. If you're really good at picking stocks most likely to succeed in the next 12 months, base your work on that endeavor. If you can foretell the next important development in the economy, or in technology, or in consumers' preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination and by continuous testing of performance, that you have what it takes to produce worthwhile results.

If you believe - as I have always believed - that the value approach is inherently sound, workable, and profitable, then devote yourself to that principle. Stick to it, and don't be led astray by Wall Street's fashions, illusions, and its constant chase after the fast dollar. Let me emphasise that it does not take a genius or even a superior talent to be successful as a value analyst. What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.

But whatever path you follow as financial analysts, hold on to your moral and intellectual integrity. Wall Street in the past decade fell far short of its once-praiseworthy ethical standards, to the great detriment of the public it serves and of the financial community itself. When I was in elementary school in this city, more than 70 years ago, we had to write various maxims in our copybooks. The first on the list was "Honesty is the best policy." It is still the best policy....."

Graham has addressed a few issues by this sharing from a veteran investor. First, there may not be only one successful approach to investing. An investor can live out any investment philosophy he is comfortable with. However, whichever investing approach an investor chooses, he must not fall in love and be deluded with it's usefulness but instead test out rigourously whether the approach really yields success in getting consistent good returns on investments.

Second, investment success is not only exclusive to the selected experts in investment field (e.g. fund managers, financial analysts, or anyone with depth of training in the field of finance and investments). The qualities essential for investment success are reasonably good intelligence, sound principles of operation and firmness of character. Of course, an investor needs to learn first to acquire a set of sound operating principles and then have the tenacity to follow through the sound operating principles for investment success. As such, one has to be careful of any distractions that promises 'seemingly fast money' based on following certain 'dubious investing methods' unless that method has been already rigourously tested for it's consistent results.

Third and last, as financial analysts, one should handle his trade with moral and intellectual integrity. As such, this is also a warning for one to view any form of research reports related to investments with healthy skepticism and objectivity since one does not know the analyst(s) behind any research reports is(are) reporting based on upmost moral and intellectual integrity.