Stock Market Investing - Why You Should Avoid Debt-Ridden Companies
James Woolley
April 06, 2009
In a high growth economy smaller businesses will often build up significant amounts of debt in order to grow their business. Therefore it's not always a bad idea to invest in these growth companies even if they have quite high debts. However in this current economic climate it is simply a recipe for disaster.
The global credit crunch has meant that banks are now much more reluctant to lend money and therefore businesses of all sizes are struggling to raise finance. Furthermore a lot of companies have found that they have built up large amounts of debt in the past in order to grow, but are now finding that they cannot get any more finance, so they are in a difficult position.
Furthermore the worldwide recession has meant that demand for a lot of these companies' products has fallen sharply. Indeed this combination of falling demand and unmanageable levels of debt has driven a lot of companies out of business, particularly in the manufacturing and retail sectors.
So if you are looking for potential companies to invest in, then I would strongly advise you stay well away from companies with significant amounts of debt. This is because in most case the profits they earn in future years simply will not be enough to service such high levels of debt, and they may well go bankrupt.
There's nothing wrong with debt in itself because nearly all stock market-listed companies have some debts. The key point though is that these debts must be manageable and easily covered by net profits.
My own general rule is to stay away from companies whose net debt figure for the latest financial year is three times greater than their net profits. I stick to this rule even in bullish markets, but in today's markets it's even more important because overall demand for products is falling, and it's still unclear how long this recession may last. It's not inconceivable that it could last for several years longer than many analysts are expecting.
Companies with debts far in excess of their net profits will always struggle to pay them off but a figure of less than three times profits is easily manageable and is not too much of a problem for most companies. So from an investment point of view I would suggest that you only consider investing in companies with low levels of debt because in this current market in particular, you could well find that your investments could turn out to be completely worthless if your chosen companies fail to service these unmanageable debts and go bust.
If you are interested in opening an account with an online broker, please click here to read a complete review of Zecco and to read a full TradeKing review.
The global credit crunch has meant that banks are now much more reluctant to lend money and therefore businesses of all sizes are struggling to raise finance. Furthermore a lot of companies have found that they have built up large amounts of debt in the past in order to grow, but are now finding that they cannot get any more finance, so they are in a difficult position.
Furthermore the worldwide recession has meant that demand for a lot of these companies' products has fallen sharply. Indeed this combination of falling demand and unmanageable levels of debt has driven a lot of companies out of business, particularly in the manufacturing and retail sectors.
So if you are looking for potential companies to invest in, then I would strongly advise you stay well away from companies with significant amounts of debt. This is because in most case the profits they earn in future years simply will not be enough to service such high levels of debt, and they may well go bankrupt.
There's nothing wrong with debt in itself because nearly all stock market-listed companies have some debts. The key point though is that these debts must be manageable and easily covered by net profits.
My own general rule is to stay away from companies whose net debt figure for the latest financial year is three times greater than their net profits. I stick to this rule even in bullish markets, but in today's markets it's even more important because overall demand for products is falling, and it's still unclear how long this recession may last. It's not inconceivable that it could last for several years longer than many analysts are expecting.
Companies with debts far in excess of their net profits will always struggle to pay them off but a figure of less than three times profits is easily manageable and is not too much of a problem for most companies. So from an investment point of view I would suggest that you only consider investing in companies with low levels of debt because in this current market in particular, you could well find that your investments could turn out to be completely worthless if your chosen companies fail to service these unmanageable debts and go bust.
If you are interested in opening an account with an online broker, please click here to read a complete review of Zecco and to read a full TradeKing review.
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