Is the Company You Invested in Conservatively Financed?

In the normal cause of business, debts are raised for expansion.  One of the purposes of having business loan is to exercise the power of leverage.  That is, use small amount of other people's money to earn big buck.  If this is the case, the business loan can be repaid easily.  How about if the case that, in actual, it does not ended as per plan?  In another scenario, there may be cases like too much debts being raised for over aggressive plans.



Imagine when you go to a bank to seek for a housing loan, what will the bank request from you?  Proof of income, consistency of income source, income tax declaration as well as your current credit status with other financial institution are the must.  When checking your credit status, the bank will check the repayment performance of you current loans as well as your total loan exposure.  They will simply reject you if either one of these fail to meet their requirement.

Similarly, before investing in a company, we should also check a company's financial status to decide whether it is over or conservatively finance.  First priority should be given to those companies that able to utilize their cash flow to finance the expansion instead of raising loan.  Only cash rich companies can do that and this may means these are low risk companies, especially when facing any unexpected business environment turmoil.

It does not mean those companies have loans are bad.  We should avoid over exposure companies by judging whether these companies are conservatively financed or not.  As a rule of thumb, a good company should be able to have a ratio of 5 or less over its long term debt to current year's net earning.  If not, drop the company. 

Where to get these info then?  Well, they can be obtained easily from respective companies financial statement, namely Income Statement (for net earnings) and Balance Sheet (for long term debt).

Happy searching.