Is the debt crisis as bad for companies as it was during the Global Financial Crisis?

We believe it is not, because all of the debt issues are sovereign debt, that is to say that countries, rather than companies are having a debt crisis. Most companies now are at their meanest and leanest for years. Companies have used several strategies to remove debt from their books. This has been done by:

• Selling non-core assets and reducing staff.
• Reducing dividends (or stopping dividend s entirely) to service debt.
• Securitising debt, by offering additional shares via rights issues to shareholders and institutional investors.
• Offering additional shares through share purchase schemes and using the proceeds to pay off debt.
• Refinancing debt at more favourable rates

So now many companies are crowing about having very little debt, whereas in the 1990’s it was considered the only way to expand and many companies carried very high levels of debt. That was because debt can leverage your buying capacity and help you to gear up income returns.

For example XYZ Pty Ltd uses $10 million of the company’s money and buys goods and makes $1 million. If XYZ Pty Ltd borrowed a further $10 million and bought $20 million of goods and make $1.8 million after borrowing costs, then it has increased its profit by 80%, without having to use any more of its own assets.

This scenario is good in strong markets, but proved deadly in the GFC as many companies caught with very high levels of debt and they were having to refinance it when banks were not lending; or if they were, they were offering very high interest rates. Many companies that could not service their debts, or sell their assets for more than they owed, went bust, or as discussed above, used strategies to securitise their debt.

Company Debt Ratios

If you divide a company's total liabilities by its total assets you will get its Debt Ratio, which is used to gain a general idea as to the amount of leverage being used by a company.

A low percentage means that the company is less in debt is in a stronger equity position. In general, the higher the ratio, the more risk that company is considered to have taken on.

So if the XYZ Pty Ltd had total assets of $50 million and liabilities of $10 million, its Debt Ratio would be 20%.

However this will overstate, to certain extent, the indebtedness of a company, because some of the liabilities would be for every-day expenses the company had to meet, such as the cost of raw materials, tax and accounts payable.

So the XZY Pty Ltd had actual loans of only $1 million, then it is only has a real debt level of 2%.

The other major way ratio might be to look at how much of the company’s assets are paid by debt and how much is paid by the shareholders equity. This is called the Debt/Equity Ratio and as with the Debt Ratio, a lower figure is better for the company.

So assuming that XYZ Pty Ltd had 50- million shares worth $2.00 each and the same liabilities of $10-million, then the company’s Debt/ Equity ratio would be 10%.

As with the Debt Ratio the debt levels will be overstated by the operational liabilities.