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.
Prerequisite readings:
In the quest for building a winning portfolio, we all strive to mitigate risk.
One effective metric used to assess a company's financial health is the Net Debt to Equity (D/E) ratio.
In my previous article, I mentioned its better to avoid starting new positions in companies which are in Net Debt position.
However, there may be instances when a company that the investor has invested in turned into a Net Debt position, and the investor will need to decide if they should close or reduce the position of the company to mitigate their risk exposure, this article is dedicated to help them do that.
Companies that have no debt can't go bankrupt. - Peter Lynch
As a rule of thumb, aim to avoid companies where their Net Debt to Equity ratio is higher than 50%
In scenarios where I need to continue dollar-cost-averaging for existing companies in my portfolio where they have turned into a Net Debt position, my benchmark will be to only continuing dollar-cost averaging on them if they can maintain a Net Debt to Equity ratio of under 50%.
One example is Microsoft, I have been investing in them since Aug 2021, and they have just recently got into a Net Debt position of -$7.4 bill since end of 2023.
However, seeming that Microsoft's Net Debt to Equity ratio is only 3%
method to calculate = - Net Debt / Shareholders' Equity
= -(-7,357) / 238,268
which is way below the 50% benchmark,
I would deem Microsoft's Net Debt level is still on the conservative side, since their Free Cash Flow amount has been consistently growing in the past too
How is Tesla's Net Debt to Equity ratio?
As of today, Tesla is in a Net Cash position,
hence they are actually in a Net Cash to Equity position of 38% (Net Cash of $23,864 divide by Shareholders' Equity of $62,634), which signals a healthy financial position in terms of liquidity & solvency.
Read How do Tesla & BYD's Finances fare against their competitors in the Auto industry? for more insights about the Debt level of Legacy Automakers.
Conclusion
The Net Debt to Equity ratio offers valuable insight into a company's financial health, particularly their ability to manage debt and remain solvent. While exceeding a 50% Net D/E ratio should raise red flags,
it's crucial to remember that this metric operates within context.
It can be useful to benchmark the Net D/E against industry standards too Different industries tend to have varying acceptable Net D/E ranges due to inherent differences in operational needs and capital expenditure requirements.
