5

How can I understand the way that way a company is using its borrowed funds?

From the balance sheet I can see how much debt the company issued, and how much is paid back. But how can I see if the debt is a “good” or “bad” debt? Can I see how the company is spending its debt, and the return it is earning from using it?

1 Answer 1

34

Money is 'fungible'. That means that any single dollar in circulation is identical to every other. If I pick up a lucky quarter on the street, and put it into my right pocket, then when I buy a candy at the store it is irrelevant whether I pay with that quarter or from a quarter I had in my left pocket. Whether you consider it a 'right pocket' quarter or a 'left pocket' quarter, I still have the same amount of money in total.

So asking 'what a company does with its debt' is basically the same as asking 'what money did the company spend in the year?'

Look at the published cashflow statement to see this - it will show incoming debt funds, debt repayments, operating cashflows, and investments in the business.

In some cases, for significant enough cash movements, the financial statements might disclose something like "such and such project required $x investment, which was partially funded through $y in additional debt".

I will caution you that this is a fairly basic concept, so if you are preparing to do some analysis of a company's financial statements for investment purposes, I suggest you keep studying before putting your own money at risk.

The question regarding determining if the debt is 'good' or 'bad' is more difficult to answer - one thing to watch for would be the income compared with annual interest costs, and also any notes which describe when the debt becomes due. This will form one part of analysis of the company's finances, and is a much broader question.

15
  • make sense to check the income/Total debt ratio? to see if the company generate a good return on it? and which is a good ratio? example Apple- Total debt:136B, Income:94.6B ->Return=69% so for each € of debt he generated 0.69cent. If we see Walt Disney they have huge debt compared to Operating cash so Total debt:58, Income:1.9- Return=3.3%, so what return value limit is good?
    – DevLeo
    Jun 6, 2022 at 17:23
  • 10
    @DevLeo Different companies and different industries will impact the necessity / risk / value of debt. "How much debt is good?" is far too complex to answer here, and if you think simple answers will provide you an 'edge' in investing, then I again caution you that you may be in over your head. Jun 6, 2022 at 17:28
  • 2
    You're right that there is no way to define "how a company is using its debt" (versus other available funds) based on the bare factual accounting data. However, as a matter of strategy and intent, it is meaningful to ask, "What did the company spend money on that it would not have done if it had not borrowed these funds?" This counterfactual is not straightforward to answer, and may be totally inscrutable from outside, but at some level there is an executive who knows the answer. If known, this could be used to evaluate whether the company showed good judgment in deciding to borrow.
    – nanoman
    Jun 7, 2022 at 2:54
  • The law, which can deal with evidence of intent and not just bare accounting data, does indeed prescribe in various cases how borrowed funds can be "used".
    – nanoman
    Jun 7, 2022 at 2:59
  • 2
    @nanoman If company A has a failing division with excess costs absorbed by net income, decides to take on debt to fund a new branch, that is functionally identical to company B funding its new branch from net income and taking on debt to continue operation of its own failing division. You could argue that company B is more foolhardy to take on debt for a failing division, and I would counter that company A doesn't even have the information gathering to understand that without its failing division, it wouldn't need to take on new debt for the new division. Jun 7, 2022 at 13:22

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .