In order for young companies to grow, they must have ample capital on hand to expand the business and take care of daily operations. For most companies, this means resort to the debt markets as a means of getting the necessary capital. There is nothing wrong with this, and it is a trademark of our vibrant economy that such a market exists. However, too much debt can crush a company. Here is a more detailed explanation of debt and some warning signs that a company might be buried in it.

What Type of Debt

There are two main ways a company can take on debt: 1) by issuing debt securities like bonds- and 2) by obtaining a bank loan.

• Debt Securities- These securities are issued by the company and purchased by investors. If you were the buyer, you would basically be lending money to the company for a given interest rate. Debt securities typically enable a firm to raise more money and to borrow for longer durations than loans typically allow. However, the downside to this is that these issuances usually dilute existing securities and push prices lower in the short term.
• Loans- Bank loans dont involve the dilution risk that debt securities do, but they usually require repayment over a much shorter time period. An advantage of this type is an open line of credit that a company can use to meet day-to-day needs. Be aware of how much loan-debt a company has and what the maturity dates are.

Be On the Lookout

When researching a company, be on the lookout for these items:

Purpose of the Debt

If a company keeps borrowing to pay off existing loans, there could be serious trouble on the horizon. A company in this situation is likely headed for bankruptcy as costs are exceeding revenues, and the only they see to get out of their hole is to keep digging.

On the other hand, a healthy, growing company will take on debt to finance new projects and initiatives. These new projects are the lifeblood of a young growth company, and will be the basis for self-sustenance going forward.

Existing Debt Levels

Check the balance sheet to ascertain how much debt the company already has. A debt-free company has plenty of latitude to take on debt to finance new projects. This is acceptable and even encouraged. A young company that is hesitant to take on any debt is probably too conservative and stands little chance of being a huge winner. Of course, the likelier scenario is a company that is already loaded with debt, and is itching to add to it.

Gauging Debt Levels

Here are a few methods to quantify the debt levels of prospective companies:

Quick Ratio: This ratio is a test that indicates whether a firm has enough short-term assets to cover its immediate liabilities without selling inventory. It can be calculated as follows:



This ratio should be comfortable over 1, and preferably much higher.

Current Ratio: This ratio measures how much coverage short term assets have over short term liabilities. A general rule of thumb is that two or better is preferable. It can be calculated as follows:



Debt to Equity Ratio: This ratio measures what proportions of equity and debt are used to finance a companys assets. Acceptable levels vary across industries, with capital intensive industries often having ratios over two, and computer companies having ratios less than 0.6. The ratio can be calculated as follows:



Assessing debt levels is more an art than a science. However, being knowledgeable about various ratios and guidelines can help you spot red flags before a company gets buried by its debt load.