For Companies in a Net Debt Position: Why an Interest Coverage Ratio of at Least 5X is Critical

Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.

KEYPOINTS

Avoiding companies in a net debt position helps reduce the risk of financial instability and potential bankruptcy.
Exceptions can be made for companies with strong fundamentals, growth potential, and a Net Debt to Equity ratio below 50%.
A minimum Interest Coverage Ratio of 5X ensures a company can comfortably manage its debt obligations and minimize financial risk.

As a general rule, I prefer to avoid companies that are in a net debt position. This is because being in net debt increases the risk of financial instability, making such companies more vulnerable to bankruptcy.

However, there are times when I make an exception to this rule. In rare instances, if a company is:

Fairly valued
Fundamentally strong
Has good growth potential that meets my targeted returns,

I may consider adding it to my portfolio, even if it carries net debt. In these situations, I apply two key criteria to ensure the company’s financial health:

Net Debt to Equity Ratio should be less than 50%
Interest Coverage Ratio should be at least 5X

Why the Interest Coverage Ratio Matters

The Interest Coverage Ratio (ICR) measures how well a company can pay the interest on its outstanding debt.

The formula for calculating the ICR is:

Interest Coverage Ratio= EBIT (Earnings Before Interest and Taxes) / Interest Expense

A ratio of 5X or more means that the company earns at least five times the amount needed to cover its interest payments. This threshold ensures that the company is not overleveraged and has enough earnings to comfortably handle its debt obligations, even during periods of lower profitability.

Where to Find This Information

To find the Interest Coverage Ratio of a company, you can use financial aggregator websites like stockanalysis.com. Here's how:

Search the company you’re interested in.
Look under Statistics.

Scroll to Financial Position and look for the Interest Coverage figure.

Example: Netflix

Let’s take Netflix as an example. Netflix has a Net Debt to Equity ratio of 42%, which is within my acceptable range. More importantly, its Interest Coverage Ratio is 13.75X, well above my 5X minimum. This makes Netflix’s debt more manageable and signals that the company is financially healthy.

Other Financial Indicators to Watch

It’s also a good sign when the company’s earnings and cash & cash equivalents are on an upward trend. This indicates that the business is not only capable of servicing its debt but also has the financial flexibility to invest in growth and weather downturns.

In summary, for companies with net debt, I require an Interest Coverage Ratio of at least 5X. This provides a solid buffer against financial risk and ensures that the company’s debt is not a drag on its long-term growth potential.