Debt Evaluation Ratios

Will you invest in a company that has a large amount of debt? That is a usual question that you would hear from every investor when they are evaluating a stock. Unfortunately, the answer is not either a “yes or no.” The actual answer is “it depends.” Because the problem is that there are some industries that typically require more debts than others do. For these industries, a higher debt load is normal.

For other industries; a large amount of debt may be a sign that something is seriously wrong.  Of course, any company might pick up a large amount of debt if it had just bought a building or a competitor. When selecting stocks to place in your trading system, it is important to determine if the company has too much debt.  There are actually several tools that you can use to determine whether a company is about to expose itself to too much debt and this tool is the stock evaluation tool and these are:

The first tool is the Debt to Equity Ratio. This is a ratio that tells you of what portion of debt and equity is being used to finance a company’s assets. The formula to do that is by computing the Total Liabilities / Shareholder Equity = Debt to Equity Ratio.

The second tool is the metric tool called the Interest Coverage that will actually provide you a good idea of how a company is having trouble in terms of paying the interest charges on its debt. The formula in computing the metric of the debt with the Interest Coverage is by computing the EBITDA / Interest Expense = Interest Coverage.

Another tool would be the Current Ratio.  This ratio tells you how easily a company is able to pay their liabilities that will come due within the next year.  The amount of debt a company is required to pay out within the next year and is known as the current maturity of debt is posted as an amount in the current liabilities, or the debt due in the next year.  Thus the current ratio will not only include things like the small debts owed by the company but also reflect whether they can meet their principle payments for the coming year.

It is important when deciding if you should buy shares in a companies stock that you know if they are living on the edge and may have to file bankruptcy because of not being able to pay their debts.