Short-Term Debt: Evaluating Financial Strength and Cash-Generating Growth

Short-term debt and current liabilities often get combined into the same bucket. When looking at the debt to equity ratio of the company, most investors calculate the ratio using the total liabilities divided by the equity.

Analyzing a company’s debt position can be useful to determine if the company uses debt to fuel the company’s growth. Which, in some cases, remains beneficial for that company.

Where danger can lurk in a company taking on more debt than it can handle, we need to measure the company’s ability to cover its interest payments. Understanding when the payments come due can significantly impact the business’s cash flow.

Investing in companies taking on too much debt can lead to disaster, so using ratios and reading the balance sheets of every company you buy remains crucial to avoid losing money. Remember Buffett’s rule number one, don’t lose money.

We have many ways to determine the viability of the company’s debt load and how to use our Sherlock Holmes and investigate the debt. Remember, not all debt is bad, just more than the company can handle.

Items we will discuss today:

What is Short-term debt

According to Investopedia:

Short-term debt, also called current liabilities, is a firm’s financial obligations that are expected to be paid off within a year. It is listed under the current liabilities portion of the total liabilities section of a company’s balance sheet.”

Companies accumulate two kinds of debt, financing, and operations. Debt from financings stems from raising capital to grow the business, whereas debt from operations stems from the running of the business and naturally occurs.

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Financial debt is typically long-term debt, which means that the obligations extend more than twelve months. The line item lists after the current liabilities under the total liability section of the balance sheet.

Operating debt comes from the necessary actions required to run the business. Items such as accounts payable, for example, expect to resolve within one year.

Operating debt is short-term debt and comprises short-term bank loans or commercial paper.

The line item concerning the short-term debt equals the subject of a quick bit of focus when determining the performance of our company. The debt-to-equity ratio helps us determine the amount of debt a company has in relation to its capital. And a higher ratio remains of concern as it regards the company’s liquidity.

If the current liabilities are higher than the cash and cash equivalents, it tells us the company might be in poor financial health and is in danger of not being able to meet its obligations and pay off all of its debts.

Current Liabilities

We have defined short-term debt; let’s further dig into the current liabilities and break down each line item from the balance sheet.

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Short-term bank loans

The most common type of current liability is a short-term loan. These loans originate from the need for companies to raise funds to operate the business and fund working capital needs. Also known as a “bank plug,” which acts as a short-term gap filler between longer loans.

On the balance sheet of AT&T, you can see the line item in current liabilities of debt maturing within one year. These long-term bank loans mature within one year. In the cash flow statement, several line items show the paying of these amounts and more short-term financing initiated.

When investigating the debt of any company, it is best to look at the notes in the financial documents section for more clarification.

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AT&T’s short debt contains a mixture of commercial paper, credit agreement debt, and long-term notes maturing, but the rest equals the long-term debt coming due.

Sometimes I feel like Sherlock Holmes is investigating to get to the bottom of what a company is doing.

Accounts Payable

Another typical short-term debt is the liability known as accounts payable. Companies use this line item to show all payments to all outside vendors and shareholders. Let’s say that the company purchases equipment for $1 million on short-term credit with the vendor, which has a term of 30 days—the $1 million remains classified as an account payable.

Salaries and Wages Payable

Depending on how a company pays its employees, salaries and wages might be considered short-term debt. For example, if the company pays an employee at the end of the month for work done in the previous month, the company would create a line item in the current liabilities to account for those owed wages until paying them at the end of the month.

Lease Payments

Most accountants consider leases as long-term debts, but some leases serve their purpose in the short term and pay off within a year. For example, if a company leased space to bottle its beer for six months, that lease fulfilled a short-term purpose and added to the line item in current liabilities.

Accrued Taxes

Everyone’s favorite taxes! Some company taxes accrue over time but have not paid to the government yet. Accrued taxes are taxes assessed to the company either on its earnings or property owed by the company.

Dividends Payable

Andrew and I’s favorite subject, dividends, The line item under current liabilities here lists dividends that have been declared but not yet paid. Again, this item is under the current liabilities; these monies the company owes to the shareholders before the end of the year.

Dividends payable refers to the declared dividend by the company.

Dividend declared is that portion of profits earned by the company that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of company’s securities and such declaration of dividend creates a liability in the books of the concerned company.”

To break that down a little bit, dividends declared are the time when the company announces it will distribute dividends to shareholders. When this event is announced, the company creates a liability on its balance sheet to account for the distribution of dividends.

The timing of the balance sheet will indicate whether the declared dividends represent quarterly or annual. Remember, the balance sheet is a snapshot in time of the company’s financial situation.

When the company pays the dividend, they remove the liability from the balance sheet, and the cash flow statement will add the cash outflow to its record.

A note about taxes on dividends, the taxes don’t accrue until paying the dividend, and the company’s those taxes along with distributing the dividends.

Unearned revenue

Unearned revenue is money that a customer advances to the company for not yet completed work but will finish in the coming year.

AT&T doesn’t have this line item on its balance sheet because the item is not part of its business model. But for a time, unearned revenue represented part of Tesla’s revenue model; people would prepay for cars not yet built but promised to deliver within the year. Magazine subscriptions present another example; you prepay for the promise of receiving the magazines throughout a year.

How Do We Analyze the Impact of Short-term Debt?

Investors have several ways to analyze the short-term debt of a company and its impact on the business. We can assess a company’s liquidity by looking at its working capital. Having excess working capital equals adequate cash to cover the short-term debt and provide growth opportunities for the company.

If the company operates on the short side of working capital, it may pose issues with its liquidity and force the company to take on more debt to cover the difference.

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We have a simple formula we can use to find the working capital.

Working Capital = Current Assets – Current Liabilities

To put this quick formula in action, let’s look at the balance sheet of Hormel (HRL). The balance sheet is dated the year ending October 31, 2021. All numbers equal millions unless otherwise stated.

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Let’s pull our numbers from Hormel’s balance sheet.

  • Current Assets – $2,947,816
  • Current Liabilities – $1,415,654

Now to find the working capital for Hormel, we add our numbers to the above formula.

Hormel Working Capital = 2,947,816 – 1,415,654

Hormel Working Capital = $1,532,162

Hormel meets the first test and has adequate working capital to reach its current liability requirements and have enough to grow.

Another quick way to determine a company’s short-term liquidity is to utilize a few other ratios.

Current Ratio

The current ratio is a quick way to compare the liquidity of peers when investigating a company. The current ratio measures the company’s ability to meet all of its current liabilities using the more liquid assets of the business.

A word of caution: a company with a high inventory level listed as a current liability would have a higher current ratio. But inventory can take time to turn into cash, so it is best to use another ratio, the quick ratio, along with the current ratio to get a full picture of the liquidity of a business.

To calculate the current ratio is simple as well.

Current Ratio = Current Assets / Current Liabilities

We can take the numbers from our previous example to calculate the current ratio for Hormel.

Current Ratio = 2,947,816 / 1,415,654

Current Ratio = 2.08

A current ratio above one is considered good, and above a 1.5 is even better, so Hormel continues to manage its current assets versus their liabilities.

But remember what we discussed about inventories in the above section? Let’s look at the quick ratio to see if this still holds true.

Quick Ratio

The quick ratio is a great additional tool to measure the short-term liquidity of any business. It includes the same current assets and liabilities of the current ratio, but we also include inventories to give us a full picture of a company’s liquidity.

Let’s take a look at the quick ratio for Hormel.

I am looking at the above balance sheet again.

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The formula for the quick ratio:

Quick Ratio = ( Current Assets – Inventories ) / Current Liabilities

We are pulling the numbers from the above balance sheet.

  • Current Assets – 2,947,816
  • Inventories – 1,369,198
  • Current Liabilities – 1,415,654

Plugging the numbers from above into the formula, we get:

Quick Ratio = ( 2,947,816 – 1,369,198 ) / 1,415,654

Quick Ratio = 1,578,618 / 1,415,654

Quick Ratio = 1.11

According to our calculations, Hormel carries sufficient current assets to meet its liquidity needs, but the quick ratio is lower than the current asset. If we didn’t see Hormel continues carrying quite a bit of inventory on its balance sheet, the omission would have thrown our number off by quite a bit.

A number below one would indicate that a company would have trouble meeting its current liability requirements.

A quick ratio is an acid test of the company’s financial strength.

Let’s look at a few more to give us a full flavor of how these ratios can work for us.

Next up Walgreen’s Boot Alliance (WBA), another dividend aristocrat.

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We are pulling the numbers from Walgreen’s balance sheet.

  • Current Assets – $15,814
  • Inventories – $8,159
  • Current Liabilities – $22,054

Now that we have all our numbers let’s calculate our ratios.

Current Ratio = 15,814 / 22,054

Current Ratio = 0.72

Quick Ratio = ( 15,814 – 8,159 ) / 22,054

Quick Ratio = 7,655 / 22,054

Quick Ratio = 0.35

Looking at Walgreen’s balance sheet, the company is experiencing a liquidity crunch and would bear some further investigating or following before buying Walgreen’s. And if you look at the previous year, the liquidity crunch appears as a trend, which I would want to investigate.

For comparison, let’s pull some more numbers just for giggles.

The above chart gives us an excellent snapshot of some different companies and their current and quick ratios. A few of the recent financial downturn poster children, Carnival and Boeing, continue feeling the short-term liquidity crunch.

When the market takes a turn for the worse like it has recently, you can see who was swimming naked as the tide has gone out.

Final Thoughts

Walking through the current liabilities and analyzing short-term debt remains a fantastic way to check the liquidity of a company you like. As we have seen, looking at the short-term debt remains easy to do, and once you understand the accounting terms, it makes much more sense.

The short-term debt includes more than just loans a company takes out to get it from point A to point B; it includes taxes, accounts payable, and dividends.

The ratios we use to analyze a company’s liquidity are quick and easy to calculate, and I would strongly encourage you to add those to your checklist. Using these ratios will help you determine two things.

  • Number one is the company is in a position of financial strength and has enough short-term liquidity to cover its debts.
  • Number two is how the management has positioned the company to grow over the long term. By focusing on creating cash-creating assets, the management can continue to grow the company instead of focusing on funding to cover the shortfall in cash to cover the liabilities.

As you can see, it is not just about the numbers; there is also an element of decisions made by management about the direction of the company. Using these ratios, we can see who is swimming with their clothes on when the tide goes out because it will go out at some point.

As always, thank you for taking the time to read this article. I hope you find something of value in your investing journey. If you have any further questions or if I can be of any additional assistance, please don’t hesitate to reach out.

Until next time.

Take care and be safe,

Dave

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