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1 crucial thing every investor needs to know about debt

When you start investing, there are a lot of things that can trip you up. On the plus side, thanks to the internet and books written by highly skilled investors, there is also very little that can’t be learned. Here is one thing every beginner needs to know about company debt:

Its Size

This is simply how much debt the company has; for example, Woolworths Limited (ASX:WOW) reported a total of $3.26 billion in borrowings at its half yearly report. It also has $1.42 billion in cash, which might lead the company to report ‘$1.84 billion in net debt’ (borrowings minus cash) instead of its total borrowings figure. This information can be found on the ‘consolidated statement of financial position’, sometimes also called the ‘balance sheet’.

That’s not rocket science”, I hear you say. You’re right, it’s not. And there are a couple of useful metrics that can help you quantify company debt and think about it in a more useful way. After all, $1.8 billion sounds like an awful lot, but as we will see it is not that significant for Woolworths.

There are a couple of useful metrics that measure the size of debt vs the size of the company.

Net debt to EBITDA

One metric is net debt divided by Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). Woolworths reported EBITDA of $1.826 billion in the first half and had $1.84 billion in net debt as we saw above. Thus it has a ‘net debt to EBITDA ratio’ of 1.01 times (higher is worse), rounded up. Many companies have their debt limited by bank ‘covenants’ (rules attached to the loans), with a common limit being 3.5x EBITDA, and unpleasant circumstances such as forced asset sales can occur if these covenants are breached.

Woolworths debt levels are quite modest compared to the size of the company and its earnings.

Gearing

A second common metric is ‘gearing’, which is net debt divided by shareholders equity (the value of funds that shareholders contributed to the company). This is most commonly used by property trusts as their shareholders’ equity is underpinned by physical investment properties. Scentre Group (ASX: SCG), for example, reports a gearing of 33%, which is moderate (higher is worse).

Using this method we can also calculate Woolworth’s gearing. Woolworths has ‘shareholders’ equity’ of $9.162 billion. If we divide its net debt figure (see above) of $1.84 billion by its shareholders equity, we get a gearing of 20%, which is quite low.

Figures above 50% to 60% are starting to get risky, although this also depends on the business model. Telstra Corporation Ltd (ASX: TLS), for example, currently has gearing of 50.4% and management’s target range for debt is between 50% to 70%. Woodside Petroleum Limited (ASX: WPL) has gearing of 24%, with a target range of 10% to 30%.

This is because it is not just the size of the debt that is important, the ability to repay it is also crucial. I’m currently writing a follow-up article on the ability to repay, which should be out tomorrow.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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