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Ask a Fool: How Much Debt Is Too Much for a Company to Have?

By Matthew Frankel, CFP® - Sep 20, 2019 at 12:00PM

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Here's what to look for in a company's balance sheet.

Q: I know that most companies use debt to help fund their operations, but how can I tell if a company's debt load is too high?

Unfortunately, there's no universal rule about how much is too much when it comes to debt, but here are three metrics that can help.

First, the debt-to-EBITDA ratio is a great metric for comparing a company's debt with others in the same industry. You can calculate this by taking a company's total debt from its balance sheet and dividing by its EBITDA, which can be found on the income statement. Normal debt levels can vary, but a debt-to-EBITDA ratio above the 4-5 range is typically considered high.

One major shortcoming of the debt-to-EBITDA ratio is that it doesn't consider the amount of interest the company is paying. Rock-solid companies can borrow money at significantly cheaper costs than those without stellar credit ratings. So the second metric you can use is the company's interest coverage, which is the ratio of its net income to the amount of interest it pays on its debt obligations. Again, this is most useful for comparing companies within the same industry.

Finally, it's important to consider net debt, not just the debt figures listed on a company's balance sheet. For example, Apple has nearly $100 billion in debt, but also has about $210 billion in cash on its balance sheet, so to simply say, "Apple has $100 billion in debt" is a bit misleading. Apple's net debt is actually negative, meaning that it could pay off all of its debt and have cash left over -- and lots of it.

None of these tells the full story of a company's debt situation all by itself. However, knowing these three metrics can help put a company's debt load in proper perspective when you're analyzing a stock.

Matthew Frankel, CFP owns shares of AAPL. The Motley Fool owns shares of and recommends AAPL. The Motley Fool has the following options: short January 2020 $155 calls on AAPL and long January 2020 $150 calls on AAPL. The Motley Fool has a disclosure policy.

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