When you're considering investing in a company or loaning it money, the book value of debt is one of the things to look at. The book value of debt is the amount the company owes, as recorded in the books. If the book value is 10 percent of the company's worth, it's a better prospect than if debt equals 80 percent of the assets.
Find the book value of debt by reading the liabilities section of the balance sheet.
A company's balance sheet has three sections: assets, liabilities and equity. The assets include everything the company owns from cash to computers and cars. The liability section lists the company's various debts. If you subtract liabilities from assets, the owner's equity is what's left. To find debt, look in the liabilities section. Standard accounting practice requires writing debts down at book value as either a current liability or a long-term liability. Long-term refers to debts that will take more than a year to pay off. For instance, the $280 owed to the electric company is a current liability, while the $20,000 loan with a 12 month payoff term is a long-term liability. You need to find three particular entries:
- Notes payable, which are written promissory notes that earn interest. Notes payable are listed in current liabilities
- Long-term debt, which is listed in the long-term liability section
- The current portion of long-term debt, which is the part due in the next year. This goes in current liabilities
You'll have to look for each entry and add them up to get the book value of debt, rather than just writing the total liabilities. The liabilities section includes entries such as accounts payable, which are bills that haven't been paid yet and that don't count toward book value. To calculate the current portion of long-term debt you may have to look at the loan repayment schedule and crunch some numbers.
For instance, a cosmetic company made $500,000 in sales last year and is looking for an investor. Looking only at that sales number before investing would be a mistake. You find out that they paid $100,000 in non-production salaries, another $200,000 in production expenses and currently owe $200,000 in long-term liabilities. When you subtract the $300,000 in salaries and production expenses from the $500,000 in sales, you are left with a $200,000 profit. With that $200,000 in long-term liabilities, the company is barely breaking even and any loss in revenue this year or next could mean a losing investment. If a similar company with only $50,000 in long term liabilities came along looking for an investor, they would have a broader profit margin, higher assets and be a safer investment bet.
It's normal for a company to finance its growth with loans or bonds, but it's not always a good strategy. If the book value of debt is too great compared to the company's assets, there's a risk it won't be able to pay the debt back. This can happen if the economy tanks and the company's cash flow drops, or if variable interest rates rise. Once you know the book value, divide the value of the debt by the assets. If the result is higher than one, that's a sign the company is carrying a large amount of debt. For example, suppose the company has $200,000 in assets and $250,000 in liabilities, giving it a 1.25 debt ratio. The risk is much higher than if liabilities were only $100,000. If the debt ratio has been going up for a while, that's an even bigger warning sign.