Analyzing companies with high debt: What is the tolerable level and when does it become a problem?

A company's debt can be a double-edged sword. On the one hand, it allows it to finance growth projects, launch new products, or expand into new markets. On the other hand, excessive debt can become an unsustainable burden and jeopardize the company's stability.

In this article, we'll explain how to understand corporate debt, what levels are generally considered acceptable, and when it becomes a red flag for investors. All in simple language, without unnecessary technical jargon.

1. Why do companies go into debt?

Taking on debt isn't, in principle, a negative thing. Many companies take out loans, issue bonds, or use lines of credit to finance projects they otherwise couldn't afford with their available cash alone. Some common reasons for taking on debt:

• Financing expansion: Opening new branches, building factories, or entering new countries.

• Investing in research and development: For example, in pharmaceutical companies that require years of testing before launching a drug.

• Covering capital expenses: Renewing machinery, updating technology, or improving infrastructure.

• Seizing opportunities: Acquiring another company or responding to an unexpected increase in demand.

  
  

When debt is used with a clear plan and managed well, it can increase profitability: instead of diluting shareholders' stake by issuing new shares, the company borrows, grows, and then repays the loan with the profits generated.

2. Analyzing companies with high debt -> “Good” debt vs. “bad” debt

Not all debt is created equal. We can think of it as a tool: a hammer is useful for building, but it can also cause damage if misused. Some characteristics of "good debt":

• It has reasonable interest rates, ideally fixed and predictable.

• It is used for productive projects that will generate more income in the future.

• It comes with a clear payment plan, backed by stable cash flows.

Instead, we talk about “bad debt” when:

• It accumulates to cover recurring operating expenses because the business doesn't generate enough money.

• It has very high or variable interest rates that can skyrocket.

• The debt level grows faster than the company's profits.

3. Key indicators for assessing a company's debt

To determine whether a company has manageable debt (and especially for analyzing companies with high debt), analysts look at several ratios or indicators. You don't need to be an expert to understand them; just know their basic idea:

a) Total Debt / Equity (Debt-to-Equity)

It measures how much the company owes in relation to the money its shareholders have invested.

• Example: A ratio of 0.5 means that for every dollar of equity, the company has 50 cents of debt.

• General rule: In many industries, a ratio between 0.5 and 1.0 is considered reasonable. A ratio above 2 may indicate a high level of debt.

  
  

b) Total debt / EBITDA

EBITDA is earnings before interest, taxes, depreciation, and amortization, i.e., the cash generated by core operations.

• Interpretation: If the ratio is 3, it means the company would need three years of operating profit to pay off all its debt (excluding interest and taxes).

• Quick guide: Less than 3 is comfortable; between 3 and 5 is high; and more than 5 is worrying.

  
  

c) Interest coverage

Compare earnings before interest and taxes (EBIT) with interest expense.

• Example: A ratio of 5 means the company earns five times what it needs to pay its interest.

• Warning sign: When the coverage ratio falls below 2, the company has less room to cover its obligations if business suffers.

4. Context matters: Not all sectors are the same

A common mistake is to apply the same standard to all industries. In reality, debt capacity varies:

• Utilities: They tend to have high debt but very predictable revenue; the market accepts this.

• Fast-growing technology companies: They prefer low debt because their business changes quickly and they need flexibility.

• Stable consumer companies: Such as food or healthcare companies, they can manage moderate debt because demand is constant.

Therefore, comparing a company only with others in its sector provides a more realistic view.

5. When debt stops being healthy

Even if the debt seemed adequate at first, certain signs indicate it could become a problem:

• Falling revenues: If sales decline, the company may struggle to pay interest.

• Rapidly rising interest rates: If the debt is variable-rate, costs can skyrocket.

• Negative free cash flow: If the business doesn't generate enough cash, debt begins to strain liquidity.

• Frequent restructurings or refinancings: This can be a sign that the company is failing to meet its deadlines.

When these factors accumulate, the company runs the risk of default (non-payment), which often leads to sharp declines in the stock price.

6. The role of risk rating agencies

Agencies such as Moody's, S&P, and Fitch assess the creditworthiness of companies and assign them a rating, similar to a personal "credit score."

• Investment grade: AAA to BBB – indicates relatively safe debt.

• Speculative or "junk bond" grade: BB+ or lower means greater risk of default.

Although it's not the only factor to consider, this rating helps investors get a quick gauge of debt risk.

7. Debt in times of crisis

Economic crises (such as those of 2008 or COVID-19) test the strength of companies. Those with high debt and little cash can face serious problems:

• Difficulty refinancing loans.

• A drop in revenue that reduces repayment capacity.

• The need to sell assets or dilute shares to obtain liquidity.

In contrast, companies with controlled debt can better withstand and even take advantage of buying opportunities in difficult times.

8. The balance between debt and growth

A company with no debt may seem secure, but it could also be missing out on growth opportunities. If profitable projects are financed solely with equity, shareholders could see slower growth. The challenge is finding a balance:

• Too much debt increases the risk of default.

• Too little debt can mean the company isn't taking advantage of its growth potential.

Investors often prefer companies that use debt strategically and keep their debt-to-EBITDA ratio at manageable levels.

9. What to look for as an individual investor

If you're not a professional analyst, you can follow some simple steps to evaluate a company's debt:

1. Review the financial statements: In the liabilities section of the balance sheet, you'll find the total debt.

2. Look at the key ratios: Debt-to-Equity, Debt/EBITDA, and interest coverage.

3. Compare with competitors: Look for data on similar companies for reference.

4. Read analyst reports and risk ratings: They give you a more complete picture.

5. Look at the trend: Stable debt is not the same as debt that grows every quarter.

   
   

10. Conclusion: Debt yes, but with a head

Debt is not the villain of corporate finance. It can be a lever for growth when used prudently and with clear objectives. The problem arises when it accumulates without a solid plan or when the economic environment changes and increases the cost of financing.

• As an investor, it's not about avoiding companies with debt, but rather understanding whether that debt is sustainable.

• A company with stable revenue, good interest coverage, and ratios within its sector's range is usually on safe ground.

• On the other hand, a business with weak cash flow and increasing debt can become a risky bet.

Analyzing debt is, ultimately, an essential part of identifying value opportunities, because it helps identify companies that not only have growth potential but also the strength to weather difficult times without jeopardizing their shareholders' investment.

At StockerOwl, we closely monitor these indicators so that, even without being an expert, you can understand whether a company is managing its debt healthily or if it's entering dangerous territory. This way, your investment decision is based on clear data, not assumptions.