Debt is a double-edged sword. To the conservative investor, it is something to avoid at all costs. To the adventurous, it is a tool that can power growth.
So, which end of the spectrum do you fall on?
If you’re on the conservative side, you probably steer clear of companies with heavy borrowings. You might prefer businesses with net cash positions, because you see excess cash and low debt as signs of discipline and safety.
If you’re more adventurous, you may gravitate toward companies that borrow to expand. These tend to be run by ambitious leaders who aim for growth. When things go well, they use capital efficiently and deliver stronger Return on Equity (ROE) for shareholders.
There are pros and cons to both camps. One values sustainability; the other values ambition and acceleration. As investors, the sweet spot often lies somewhere in between.
To help you get there, let’s look at when debt makes sense, when it doesn’t, and the key metrics you can use to judge a company’s debt level. With these tools, you can build a conservative portfolio filled with high-quality companies that use debt prudently.
When does debt make sense?
Imagine yourself as a bank officer. You lend money only to borrowers who can repay you, and you judge that based on their income or cash flow. The higher the income, the more they can borrow.
The same logic applies to companies. A company might owe RM1 billion, but if it generates RM2 billion in operating cash flows each year, it could technically clear all its debt in six months. That’s a very different situation from a company with low or inconsistent cash flow.
A personal example makes it clearer. If you owe RM1 million on a home loan but earn RM2 million a year, that debt isn’t a major burden. You know you could pay it off quickly if you needed to.
But if your income barely covers your monthly bills, the same RM1 million mortgage becomes stressful – even dangerous.
This is why many investors have no problem putting money into companies with debt. What matters is strong operating cash flow, not the presence of debt itself.
Now let’s look at three useful ways to assess a company’s debt levels.
1. Debt to asset ratio
Consider two businesses that each earns RM20 million in net profit a year. Both have 100% cash conversion, so their annual operating cash flow is also RM20 million.
Both operate using RM100 million in total assets. The difference lies in how they are financed.
Company A: financed with RM100 million in equity and zero debt
Debt to asset ratio
= Debt / asset × 100%
= RM0 / RM100 million × 100%
= 0%
ROE
= Net profit / equity × 100%
= RM20 million / RM100 million × 100%
= 20%
Company B: financed with zero equity and RM100 million in debt
Debt to asset ratio
= RM100 million / RM100 million × 100%
= 100%
ROE
= RM20 million / RM0 × 100%
= Infinite
So is Company A “better” than Company B? In terms of generating profit and cash flow – no, they are identical. But Company B is more capital-efficient because it uses borrowed funds instead of equity.
A simple property example makes this clearer:
- You own a RM1 million home with a RM200,000 mortgage.
- Debt to asset ratio = RM200,000 / RM1,000,000 × 100% = 20%
- You earn no income from this home because you live in it.
Now imagine refinancing and cashing out RM300,000 to buy a RM300,000 rental property. You now hold RM1.3 million in assets and owe RM500,000 in mortgage, while your equity remains RM800,000.
- Debt to asset ratio = RM500,000 / RM1,300,000 × 100% = 38%
- And you now earn RM500 a month in rental income.
This is capital efficiency – the smart use of debt to create income.
2. Interest coverage
Interest coverage shows how many times a company can pay its interest expenses using its operating profit.
Interest coverage
= earnings before interest and taxes (EBIT) / interest expense
For example:
Company A
- Debt: RM1 billion
- EBIT: RM60 million
- Interest: RM30 million
Interest coverage = RM60 million / RM30 million = 2.0
Company B
- Debt: RM2 billion
- EBIT: RM600 million
- Interest: RM60 million
Interest coverage = RM600 million / RM60 million = 10.0
Even though Company B owes more, it handles its interest obligations far more comfortably. Higher interest coverage indicates stronger financial stability.
It’s like a person earning RM10,000 a month and paying RM1,000 in interest, versus someone earning RM20,000 and paying RM10,000. The second person earns more, but their debt burden is heavier and far more stressful.
3. Debt to operating cash flow
This is a solid method, even though it rarely appears in accounting textbooks. It tells you how many years a company needs to repay its total debt using its current operating cash flow.
Debt to operating cash flow
= Debt / operating cash flow
For example:
Company A
- Debt: RM1 billion
- Operating cash flow: RM50 million
- Debt to operating cash flow = RM1 billion / RM50 million = 20 years
Company B
- Debt: RM2 billion
- Operating cash flow: RM1 billion
- Debt to operating cash flow = RM2 billion / RM1 billion = 2 years
Despite having more debt, Company B could repay it 10 times faster. That makes it the more conservative, financially secure company.
In conclusion, the key to understanding debt is not how big the number looks, but whether the company can comfortably repay it using its profits and cash flow.
- Interest coverage – The higher, the safer.
- Debt to operating cash flow – The lower, the better.
Companies that score well on both are usually profitable, steady performers that handle debt responsibly. And when debt is used wisely, it can be a powerful engine that boosts long-term returns.
This article first appeared in KCLau.com.
Ian Tai is a financial content writer, dividend investor, and author of many articles on finance featured on KCLau.com in Malaysia, and ‘Fifth Person’, ‘Value Invest Asia’ and ‘Small Cap Asia’ in Singapore.