Debt Levels: The Double-Edged Sword
Debt can supercharge returns—or destroy a company. Understanding leverage is crucial for assessing quality.
Why Companies Use Debt
The Good
- Cheaper than equity — Interest is tax-deductible
- Amplifies returns — Earn more on borrowed money
- Maintains ownership — No dilution for existing shareholders
- Enables growth — Fund expansion without waiting
The Bad
- Must be repaid — Regardless of business performance
- Interest payments — Reduce profits
- Bankruptcy risk — Too much debt can kill a company
- Limits flexibility — Covenants restrict actions
The Mortgage
Buying a house with a mortgage is using leverage:
- Good scenario: House appreciates 20%, you only put 20% down → Your return is 100%!
- Bad scenario: House drops 20%, you still owe the full mortgage → You're underwater
Corporate debt works the same way. It amplifies both gains AND losses.
Key Debt Metrics
1. Debt-to-Equity Ratio
Formula: Total Debt ÷ Shareholders' Equity
| D/E Ratio | Interpretation |
|---|---|
| 0 - 0.5 | Conservative, low leverage |
| 0.5 - 1.0 | Moderate leverage |
| 1.0 - 2.0 | Significant leverage |
| 2.0+ | High leverage (risky) |
2. Interest Coverage Ratio
Formula: Operating Income ÷ Interest Expense
| Coverage | Interpretation |
|---|---|
| 10+ | Very safe |
| 5 - 10 | Comfortable |
| 2 - 5 | Adequate |
| Below 2 | Dangerous |
3. Net Debt to EBITDA
Formula: (Total Debt - Cash) ÷ EBITDA
| Ratio | Interpretation |
|---|---|
| 0 - 1 | Very low leverage |
| 1 - 2 | Low leverage |
| 2 - 3 | Moderate leverage |
| 3 - 4 | High leverage |
| 4+ | Very high leverage |
Key Takeaways
- Debt amplifies returns but also risk
- Debt-to-Equity shows leverage level
- Interest Coverage shows ability to pay interest
- Lower debt generally means higher quality
Debt by Sector
Some industries naturally carry more debt:
| Sector | Typical D/E | Why |
|---|---|---|
| Utilities | 1.0 - 2.0 | Stable cash flows support debt |
| REITs | 0.5 - 1.5 | Asset-backed, predictable income |
| Banks | 8 - 12 | Leverage IS the business model |
| Technology | 0 - 0.5 | Cash-rich, low capital needs |
| Consumer Staples | 0.5 - 1.0 | Stable business supports moderate debt |
Key insight: A D/E of 1.5 is concerning for tech but normal for utilities.
When Debt Is Dangerous
🚩 Red Flags:
- Rising debt levels — Borrowing to survive, not grow
- Declining interest coverage — Profits can't cover interest
- Debt-funded dividends — Borrowing to pay shareholders
- Refinancing risk — Large maturities coming due
- Covenant violations — Breaking loan agreements
Cyclical Industries + High Debt = Danger
Airlines, hotels, and retailers with high debt often fail in recessions.
The 2008 Lesson
Many "quality" companies with high debt failed in 2008-2009. Lehman Brothers, Bear Stearns, and countless others were profitable—until they weren't. Debt turned temporary problems into permanent failures.
When Debt Is Acceptable
✅ Green Flags:
- Stable, predictable cash flows — Can reliably service debt
- Low interest rates locked in — Cheap, long-term debt
- Asset-backed — Real assets securing the debt
- Strategic purpose — Funding growth, not survival
- Strong coverage ratios — Plenty of cushion
Quality Companies and Debt
High-quality businesses often have:
- Low or no debt — Don't need it
- Net cash positions — More cash than debt
- Flexibility — Can borrow if needed at good rates
- Conservative management — Prioritize stability
Examples of low-debt quality:
- Apple (net cash positive)
- Google (minimal debt)
- Berkshire Hathaway (insurance float, not traditional debt)
Debt Traps
- Ignoring debt because other metrics look good
- Assuming stable companies can handle any debt level
- Not checking debt maturities (when it's due)
- Comparing debt levels across different industries
How ShareValue.ai Uses Debt Metrics
Our Quality and Health Scores incorporate debt by:
- Comparing D/E to sector norms — Is leverage appropriate?
- Checking interest coverage — Can they pay the interest?
- Tracking trends — Is debt rising or falling?
- Penalizing excessive leverage — High debt lowers scores
Next up: How ShareValue.ai calculates the Quality Score.