First let’s clarify what bankruptcy means. We all know it’s a bad thing, but the use of the word interchangeably with other terms for financial calamity can cause a bit of confusion when it comes to financial analysis.
Bankruptcy is the legal process through which companies which cannot pay their creditors may seek relief from their indebtedness. The legal process is initiated when a company is deemed insolvent - meaning it can’t pay the debts that it owes to its creditors or meet its financial obligations on time.
And so, to monitor companies for bankruptcy risk, it's important to have a good understanding of company solvency and indebtedness. The following article aims to help investors of all levels of expertise get to grips with debt and solvency. We’ll be starting with the basic elements that can act as red flags - these are useful to help novices (who perhaps don’t have the time to dig exhaustively through company accounts) identify companies that it might be best to avoid. We’ll then go on to explore more advanced analysis techniques, perhaps for those of you who are looking for short ideas.
What is the company’s net debt position?
Net debt is the sum of all short and long-term debt minus cash.
Companies report all the individual elements of their cash and debt on their balance sheet, separated into money owed in the short term (normally defined as less than one year) and money that is owed in the long term.
To add confusion to what should really be quite a simple metric, there is no one definition of net debt. Some companies include the money owed to all creditors in their net debt figure (this might include the money owed to a pension scheme, for example). Other companies have multiple elements that contribute to their cash position (such as short-term investments in equity markets).
In order to compare like-with-like it is best to stick to one clear definition of net debt. At Stockopedia, we like: “the sum of all Short Term Debt, Notes Payable, Long Term Debt and Preferred Equity minus the Total Cash and Equivalents and Short Term Investments for the most recent reporting period.”
It is generally accepted that high levels of net debt are a bad thing. But taken in isolation, the net debt…
