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

Short term debt and current liabilities often get combined into the same bucket, but are they the same? 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 the debt situation of a company can be useful to determine if the company is using debt to fuel the growth of the company. Which, in some cases, is beneficial for that company.

Where danger can lurk is in the situation of a company taking on more debt than they can handle, this is why measuring the company’s ability to cover its interest payments, or understanding when the payments are due can have a significant impact on the cash flow of the business.

Investing in companies that take on too much debt can lead to disaster, which is why using ratios and reading the balance sheets of every company you buy is crucial to avoid losing money. Which is Buffett’s rule number one, don’t lose money.

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

Items we will discuss today:

  • What is Short-Term Debt
  • Where Can We Find Short-term Debt?
  • How to Measure Our Debt Load
  • Comparing Short-term Debt to Current Liabilities

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.”

There are two types of debts that a company accumulates, financing and operations. Debt from financings stems from raising capital to grow the business where debt from operations stems from the running of the business and are naturally occurring.

Financial debt is typically long-term debt, which means that the obligations are more extended than twelve months, and this line item is listed after the current liabilities under the total liability section of the balance sheet.

Operating debt comes from the necessary actions that are required to run the business. Items such as accounts payable, for example, and are expected to be resolved within one year.

Operating debt is known as short-term debt and is typically made up of short-term bank loans, or commercial paper.

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

Simply put, if the current liabilities are higher than the cash and cash equivalents, this tells us that 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

Now that we have defined short-term debt let’s dig into the current liabilities a little further and breakdown 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 of companies to raise funds to operate the business and fund working capital needs. Also known as a “bank plug” because it is a short-term gap filler between longer loans.

You can see on the balance sheet of AT&T the line item in current liabilities of debt maturing within one year. That would be the long-term bank loans that are maturing within one year. In the cash flow statement, several line items are showing some of these amounts being paid, as well as more short-term financing being initiated.

When investigating the debt of any company, it is best to look at the notes to the financial documents section for more flavor of what is going on.

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As we can see from above, the notes show that AT&T did have a short-term bank loan of $4 million that was due that year, but the rest of the notes maturing was the long-term debt that was coming due.

Sometimes I feel like Sherlock Holmes 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 will be 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 an employee is paid at the end of the month for work done in the previous month, then the company would create a line item in the current liabilities to account for those owed wages until they are paid at the end of the month.

Lease Payments

Typically leases are considered long-term debts, but there can be leases that are meant to be fulfilled in the short-term and paid off within a year. For example, let’s say a company leased space to bottle its beer for six months, then that lease would be considered a short-term lease and added to the line item in current liabilities.

Accrued Taxes

Everyone’s favorite taxes! These are taxes the company has accrued over time but have not been paid to the government. 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, because this item is under the current liabilities, these are 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 these are the quarterly dividends that are declared or whether they are the annual dividend. Remember that the balance sheet is a snapshot in time of the financial situation of the company.

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

A note about taxes on dividends, they are assigned when the dividend is declared; however, they are not paid until the dividend is distributed, and then they are paid along with the dividend.

Unearned revenue

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

AT&T doesn’t have this line item on their balance sheet because that is not really part of their business model. But for a time that was part of Tesla’s model, people would prepay for cars that were not built yet but were promised within the year. Another example would be a magazine subscription; you prepay for the promise of receiving the magazines throughout a year.

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

There are several ways to analyze the short-term debt of a company and its impact on the business. We can asses a company’s liquidity by looking at its working capital. Having excess working capital means there are adequate to cover the short-term debt and provide growth opportunities for the company.

The flip side of that is if the company is on the short side of working capital, it may pose issues with their liquidity and force the company to take on more debt to cover the difference.

To find the working capital, there is 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 year ending October 27, 2019. All numbers will be in millions unless otherwise stated.

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

  • Current Assets – $2,361,413
  • Current Liabilities – $1,105,049

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

Hormel Working Capital = 2,361,413 – 1,105,049

Hormel Working Capital = $1,256,364

It appears that Hormel meets the first test and has adequate working capital to reach it’s current liability requirements and have enough to grow.

Another quick way to determine the short-term liquidity of a company 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 is a measure of 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, which is listed as a current asset, 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 = $2,361,413 / $1,105,049
Current Ratio = 2.13

A current ratio above one is considered good, and above a 1.5 is even better, so it appears that Hormel is doing an excellent job of managing their 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 the liquidity of a company.

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 – $2,361,413
  • Inventories – $1,042,362
  • Current Liabilities – $1,105,049

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

Quick Ratio = ( $2,361,413 – $1,042,362 ) / $1,105,049
Quick Ratio = $1,319,051 / $1,105,049
Quick Ratio = 1.19

According to our calculations, Hormel is carrying sufficient current assets to meet its liquidity needs, but notice that the quick ratio is lower than the current asset and if we didn’t see that Hormel is carrying quite a bit of inventory on its balance sheet it 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 take a 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 – $18,700
  • Inventories – $9,333
  • Current Liabilities – $25,769

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

Current Ratio = $18,700 / $25,769
Current Ratio = 0.72

Quick Ratio = ( $18,700 – $9,333) / $25,769
Quick Ratio = $9,367 / $25,769
Quick Ratio = 0.36

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

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

That is an excellent snapshot of some different companies and what they are all experiencing right now. You can see a few of the poster children of the recent financial downturn Carnival and Boeing that are 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 as gone out.

Final Thoughts

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

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

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

  • Number one is the company in a position of financial strength and has enough short-term liquidity to cover its debts.
  • Number two, 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 on 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,