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 reading:
Red flags in your portfolio? Look beyond total debt and focus on net debt, which considers a company's cash cushion. Why?
Debt isn't bad, but too much can be risky. Net debt tells you how much debt remains after accounting for readily available cash, giving a truer picture of a company's financial health.
High net debt = potential red flag. It means less wiggle room to handle unexpected events or invest for growth.
Higher risk of bankruptcy: Companies with positive net debt are more likely to go bankrupt than companies with negative net debt. This is because they have more difficulty meeting their debt obligations during difficult times, and also during periods when interest rates is high.
Less flexibility: Companies with positive net debt have less flexibility to invest in growth opportunities or to weather economic downturns. This is because they have to use their cash flow to service their debt.
"Smart men go broke three ways - liquor, ladies and leverage." - Charlie Munger
For example, Ford Motors's has been in a Net Debt position since the last decade.
And their stock price in same duration has been decreasing too.
Although there is no clear correlation between a company's Net Debt position and their stock price movements, but investors in general would prefer to invest in companies with lower gearing ratios.
Conclusion:
Companies in a net debt position have higher risks of going bankrupt.
They also typically have lower profitability and less flexibility.
Investors should aim to avoid investing in companies in Net Debt position, especially if they have low growth rates.
(Caveat: Of course, not all companies with positive net debt are bad investments.
refer to Microsoft as an example here.
Some companies may use debt to finance growth initiatives that will ultimately lead to higher profits.
refer to Apple as an example here.)
