Company debt is a perfectly normal part of the capital structure of many businesses, so the mere presence of debt on a balance sheet should not be taken as a black mark.
What is significant is the level of debt and how it compares to
There are three ratios to calculate:
Total Liabilities/Shareholders' Funds x 100 = Percentage
As a value investor you should look for low capital gearing which means lower than 100%.
Current Assets - Current Liabilities
The Net Asset Value of a company is the money it uses to finance its daily operations. A positive figure shows that the company has the ability to pay its current obligations from its current assets. Expressed as a ratio (current assets/current liabilities), a value investor should seek companies with a current ratio of 2; that is, one which has £2 of current assets for every £1 of current liabilities.
Another useful measure is the Net Asset Value per share, which is calculated by dividing the Net Asset Value by the number of shares in issue. So if a company has £100m of Current Assets, and £50m of Current Liabilities, and 25m shares in issue, the NAV per share is £2.00. That is useful information if the shares are currently trading at £1.75.
The Acid Test is even more stringent than the NAV test, because it takes away the value of the company's inventory from the Current Asset Value. The ratio is:
Current Assets - Inventory - Current Liabilities
A ratio of 1 or more shows that the company would be able to satisfy its obligations even if all sales were abruptly terminated.
From a value investor's point of view, that is a comforting thought.
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