Net Financial Debt and Ratios: Analyzing Leverage & Risk

by | Investment Analysis

Net financial debt and the balance sheet are the foundation of a company’s business and the safety of any dividend.  A company’s liquidity and the leverage used play a big role in the success or failure of a business. That makes having meaningful and accurate metrics for analyzing leverage and liquidity a key part of investment analysis.

Net Financial Debt (NFD) Calculation

Net Financial Debt =
Financial Debt (Long Term Debt + Current Portion Debt + Dividends Payable + Notes Payable)
– (minus) Cash and Short-Term Investments

Financial Debt is a measure of a company’s non-operational debt. Operational debt would include items such as accounts payable. We want to focus on what is usually longer term obligations that are not dependent on day to day operations. This is why we isolate Financial Debt.

Cash and Short Term Securities have become a major consideration in analyzing the financial position of a corporation. Some companies are keeping billions, or even 10’s of billions overseas, in order to save on tax expense.

Net Financial Debt gives “credit” back to the Financial Debt metric in order to calculate a truer picture of the financial position of the company. For example a company that has 50 billion in financial debt but 75 billion in cash and short-term securities would have a negative Net Financial Debt of 25 billion. That is significantly different than only looking at their 50 billion in financial debt!

Risk Assessment

Net Financial Debt to Market Capitalization

This is the metric I use in the Dividend Analyzer:

Net Financial Debt  /  Market Capitalization

Comparing Net Financial Debt to Market Capitalization tells us how much of the company is leveraged compared to the total price of the company.

Remember, Market Capitalization is the total valuation of a company’s equity. Dividing the Net Financial Debt by Market Capitalization provides a key metric for accessing the risk of the company due to leverage.

By using Market Capitalization the analyst is ascertaining how much of the price paid for the stock is leveraged.

Everything else being equal, companies with a low or negative Net Financial Debt / Market Capitalization would be less risky than companies with a high ratio. A negative number means the company has more cash than financial debt.

The Arbor Investment Planner’s Dividend Analyzer awards Net Financial Debt / Market Capitalization Ratio 16 points (out of 100) to our scoring formula. This is tied with Gross Profitability as the most important metrics for finding the best dividend stock opportunities.

Net Financial Debt to Total Assets Ratio

Comparing Net Financial Debt to Total Asset tells us how much a company’s assets are leveraged after accounting for their cash and short term securities.

The higher the ratio the more leveraged the company and the greater the probability of adverse conditions affecting the company (or its dividend) in a negative manner.

Everything else being equal, companies with a low or negative Net Financial Debt / Total Assets Ratio would be less risky than companies with a high ratio. A negative number means the company has more cash than debts.

A Net Financial Debt to Total Assets Ratio in excess of 50% would be a warning sign of too much leverage. A negative ratio is outstanding and would indicate the company had more cash than debt.

Net Financial Debt to EBITDA Ratio

Calculation: Net Financial Debt / EBITDA

This calculation will tell you how many years (100% = 1 year) it would take to pay back company financial debt if they could use all their cash, short term securities, and current annual EBITDA (earnings before interest, taxes, depreciation & amortization).

This is a leverage ratio that provides information on how easy or difficult it may be for the company to reduce its debt. Ratios in excess of 300% could be a warning sign. Ratios under 100% would be considered very positive.

Recap

Net Financial Debt and its ratios are an effective and efficient approach to analyzing companies. These metrics are more important than ever because of the corporate trend to leave cash overseas and borrow domestically.

The balance sheet is the foundation from which a company operates its business. A company’s liquidity and the leverage used play a big role in the success or failure of a business. Net Financial Debt is a critical metric for analysis.

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Disclaimer
While Arbor Investment Planner has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability, or completeness of third-party information presented herein. The sole purpose of this analysis is information. Nothing presented herein is, or is intended to constitute investment advice. Consult your financial advisor before making investment decisions.

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