Investigating a Company’s Use of Debt During Due Diligence

Introduction

When you're digging into a company during due diligence, analyzing its debt is crucial because it reveals how the business manages its obligations and funds growth. Debt acts as a double-edged sword-it can fuel expansion and opportunity but also threaten financial stability if mismanaged. Understanding a company's debt profile helps you assess its financial health and growth potential, while offering insights into operational risks and the pressures that could impact valuation. This makes debt analysis a key step in evaluating both the risks you're taking and the price you're willing to pay.

Investigating a Company's Use of Debt During Due Diligence

Distinguish between short-term and long-term debt

You need to separate a company's debt into short-term and long-term categories because they affect liquidity and financial stability differently. Short-term debt usually means obligations due within 12 months, like lines of credit or commercial paper. These debts can pressure cash flow and require ready liquidity. Long-term debt spans over a year, often bonds or bank loans, providing funding for growth but creating longer-term repayment risks.

When reviewing financials, check the balance sheet's current liabilities section for short-term debt and non-current liabilities for long-term debt. This split helps you see if the company may face refinancing pressure soon or if it has manageable repayment schedules stretching into the future.

Best practice: evaluate if short-term debt levels rise disproportionately, which could signal liquidity stress, or if long-term debt growth aligns with capital investments and strategic expansion.

Identify secured vs unsecured obligations

Understanding whether debt is secured or unsecured matters for risk assessment. Secured debt is backed by specific assets-like property, equipment, or receivables-giving lenders collateral they can seize if the company defaults. Unsecured debt has no collateral, so lenders face higher risk and usually demand higher interest rates.

During due diligence, dig into the company's debt agreements or notes in financial reports to spot secured obligations. If a large portion of debt is secured, it may restrain asset flexibility. Unsecured debt offers more operational freedom but increases financial risk in downturns.

Action tip: quantify the share of secured vs unsecured debt to judge both creditor exposure and the company's asset burden. For example, a company with 50% secured debt may have less borrowing room but lower refinancing risk in crises.

Review any convertible debt or hybrid instruments

Convertibles and hybrid debt bring extra layers to debt analysis. Convertible debt can turn into equity under specific conditions, diluting existing shareholders but reducing cash interest costs. Hybrid instruments mix features of debt and equity, like preferred shares with mandatory interest-like dividends.

Check if the company has issued convertible bonds or preferred securities, as these affect both valuation and risk. Convertible bonds generally come with lower interest rates due to attached conversion options, but they introduce uncertainty about future ownership structure.

Step to take: review the terms of these instruments carefully - conversion price, maturity, triggers for conversion - because they influence cash flow, leverage ratios, and shareholder dilution risk. If a company has $100 million in convertibles due in the next 2 years, that's a red flag for potential equity dilution you should factor into valuation.

How has the company's debt level changed over time?

Historical debt trends from recent fiscal years

Start by gathering the company's debt figures over the last three to five fiscal years. Look at total debt values, separating short-term and long-term portions to see the full picture. For 2025, if the company carries $450 million in total debt, check how this compares to, say, $350 million in 2023 and $400 million in 2024 to spot growth, reduction, or volatility.

Identify patterns such as steady increases that might indicate aggressive expansion or sharp drops signaling debt paydown or refinancing. Drastic swings could suggest reactive financial management or shifts in capital strategy.

Impact of debt changes on cash flow and profitability

Changes in debt levels directly affect both cash flow and profitability. For example, a spike in debt increases interest expenses, which lowers net profit margins. If interest costs rose from $15 million in 2023 to $25 million in 2025, verify whether operating cash flows kept pace to avoid liquidity stress.

Analyze cash flow statements focusing on operating cash flow vs interest payments and principal repayments. A company borrowing more but failing to generate sufficient free cash flow may face solvency risks. Conversely, well-timed debt increases for growth projects could boost future profitability despite short-term margin pressure.

Correlation with business cycles or strategic moves

Map debt level changes to the company's broader business cycles and key strategic moves. For instance, a rise in debt might coincide with acquisitions, large capital expenditures, or market expansion. If the company's debt jumped by 30% mid-2024, review if this matched acquisition of a competitor or launch of a new product line.

Also, consider external business cycles-economic downturns might trigger debt reduction to strengthen balance sheets, while growth phases encourage leverage use. Spotting these links helps predict if current debt levels are strategic or reactive, informing your risk assessment and valuation accuracy.

Investigating a Company's Debt Servicing Capabilities

Analyzing Interest Coverage Ratio and EBITDA to Interest Expense

The interest coverage ratio measures how easily a company can pay interest on outstanding debt with its earnings. It's calculated by dividing EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) by interest expense. For example, if a company reports EBITDA of $500 million and interest expense of $50 million, its interest coverage ratio is 10x. That means the company earns 10 times the interest it owes, indicating strong debt servicing ability.

A ratio below 1.5x is a red flag - the company might struggle making timely interest payments, increasing default risk. Look for consistent coverage above 3x as a healthy buffer. Also, check EBITDA quality: Is it steady cash-generating profit, or influenced by accounting charges? Real cash flow backing these payments matters most.

Evaluating Cash Flow Adequacy for Principal and Interest Payments

Interest is only part of debt servicing. The company also needs to repay principal on schedule. The best gauge is operating cash flow relative to total debt service (interest plus principal). Say the company pays $70 million in interest and principal annually, but generates only $60 million in operating cash flow-that's a warning sign.

Focus on:

What this misses: short-term liquidity, where working capital management and cash reserves matter. The company must have enough ready cash or credit lines for upcoming debt obligations to avoid refinancing pressures or distress.

Assessing Covenant Compliance Risks Connected to Debt

Debt agreements often include covenants-conditions to protect lenders, like maintaining minimum interest coverage or maximum leverage ratios. Breaching these can trigger defaults, forcing urgent renegotiation or penalties.

Step one: identify all financial covenants in loan documents or bond indentures. Step two: analyze recent financial results and forecasts to spot potential breaches. For instance, a covenant might require an interest coverage ratio above 2.5x, but the company's forecast shows 2.2x. This gap signals a covenant risk.

Also, consider:

Ignoring covenants or misunderstanding them invites sudden financial distress. Make covenant analysis a recurring part of due diligence and ongoing financial review.

Investigating the Cost of the Company's Debt

Average interest rate on outstanding debt

Understanding the average interest rate a company pays on its debt is crucial to evaluating financial health. This rate directly affects the company's interest expense, impacting net income and cash flow. You start by gathering the weighted average interest rate from the latest fiscal year's financial disclosures. For example, a company with 5% average interest on $500 million debt faces $25 million in annual interest costs.

Keep in mind, this average blends rates on various loans and bonds. A higher rate often signals riskier borrowing, which can pressure earnings and reduce funds for growth. Track this rate's trend over the past three to five years to spot increasing borrowing costs driven by credit rating downgrades or shifts in market conditions.

High average rates can limit expansion options, so question if the company is negotiating better terms or consolidating debt. If the average interest is significantly above peers, that's a red flag worth deeper inquiry.

Comparison of fixed vs floating rates and refinancing risks

Knowing whether debt carries fixed or floating interest rates shapes how sensitive the company is to market rate changes. Fixed-rate debt locks interest costs, providing stability but possibly higher upfront rates. Floating (or variable) rates fluctuate with benchmarks like LIBOR or SOFR, exposing the company to rising rates but often starting lower.

For instance, if interest rates spike due to inflation pressures, loans with floating rates will increase interest expenses, squeezing margins. If a company has 60% floating rate debt and rates rise by 2 percentage points, interest payments increase sharply.

Refinancing risk is another factor-it's about debts maturing that the company needs to replace or repay. If refinancing happens when rates are high or credit conditions are tight, borrowing costs soar or access to funds tightens. Look for upcoming maturities in the next 1-3 years and assess market conditions. A company heavily reliant on frequent refinancing faces higher risk, especially if rates trend up or cash flow is unstable.

Effect of debt cost on overall capital structure and margin

The cost of debt influences the capital structure-the mix of debt and equity financing-and ultimately impacts profitability. Debt with expensive interest drains operating income, while cheap debt can amplify returns on equity but increase risk.

Here's the quick math: higher interest reduces net profit margin, lowering the company's ability to reinvest or pay dividends. For example, on $1 billion revenue, an extra 1% interest rate on $400 million debt reduces net income by about $4 million annually, shrinking profit margins noticeably.

Debt cost also affects Weighted Average Cost of Capital (WACC). As interest expense rises, WACC can increase, making new projects or acquisitions less attractive financially. Companies balancing a low debt cost with reasonable leverage create more shareholder value; too much expensive debt tilts this balance unfavorably.

Review if high debt costs are being offset by efficient operations or strong EBITDA growth. If not, the company's margin and competitive position could be at risk if interest rates stay high or rise further.

How does the company's leverage compare within its industry?

Benchmark debt-to-equity and debt-to-EBITDA ratios

Start by gathering the company's latest debt-to-equity ratio and debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio. These ratios give you a snapshot of how leveraged the company is relative to its equity and operating earnings. For example, a debt-to-equity ratio above 2.0 often signals high leverage, but the acceptable level varies widely by industry. In capital-intensive industries like utilities or telecom, ratios around 3.0 or higher might be standard. Meanwhile, tech companies generally keep this ratio under 1.0.

Look at the debt-to-EBITDA ratio to understand repayment capacity. A ratio under 3.0 often means the company can handle paying down debt comfortably, though some cyclical industries tolerate up to 4.0 or 5.0 during downturns. Track how these ratios compare to direct competitors to see if the company leans more heavily on debt or stays conservative.

Market standards for acceptable leverage levels

Each industry has its own tolerance for leverage influenced by cash flow stability, asset tangibility, and growth prospects. For instance, manufacturing firms with steady cash flows generally operate with debt-to-equity around 1.5 to 2.5, whereas startups often carry less debt to avoid risk until they reach positive cash flow.

Use financial data services or industry association reports to identify benchmarks. If a company exceeds the typical debt levels significantly, you need to ask why: is it funding aggressive growth, or masking liquidity problems? Also, factor in economic cycles-higher leverage can look riskier when interest rates rise, pushing debt servicing costs up.

Implications for credit ratings and investor perceptions

Leverage influences how credit rating agencies view the company's risk. Higher debt means ratings can be cut if earnings or cash flow appear volatile, which raises borrowing costs. For example, companies with debt-to-EBITDA above 4.0 might find their credit ratings downgraded to speculative grade, warning investors about default risk.

Investors also watch leverage closely because it affects equity risk. A highly leveraged firm might deliver higher returns in good times but poses bigger losses during downturns. Transparency about debt plans and strong covenant compliance generally soothe investor concerns even at moderate leverage levels.

Investigating a Company's Debt Contingencies and Risks

Potential Triggers for Defaults or Covenant Breaches

When you analyze a company's debt, identifying what could cause it to default or violate debt covenants is crucial. Debt covenants are conditions lenders impose on borrowers, like maintaining minimum financial ratios or limits on additional borrowing.

Watch for:

Review loan agreements carefully to spot these triggers early. Set up monitoring systems for covenant compliance to avoid surprise defaults.

Off-Balance-Sheet Obligations and Guarantees

Debt risks extend beyond what shows on the balance sheet. Off-balance-sheet items can include lease commitments, guarantees for subsidiaries, or derivative liabilities. These obligations may expose the company to hidden risks.

Dig into footnotes and management discussion in financial reports to uncover these items. Even a small guarantee can become a big problem if the primary borrower defaults.

Plans for Debt Reduction or Restructuring Under Different Scenarios

Understand the company's strategies for managing its debt if conditions change. Debt restructuring may include refinancing, extending maturities, or negotiating new terms to ease payment burdens.

Best practices include:

Look for clear disclosures and management commentary on these plans in the most recent fiscal 2025 reports. Companies with solid restructuring protocols adapt faster and improve their financial stability.