1. Volatile revenue streams

Lenders demand that interest and principal payments are made on time and in full. But when a firm has a volatile revenue stream its ability to meet these regular payments is less certain. The problem is compounded when a business is burdened with high fixed costs — the costs of simply keeping the doors open even if it's not doing any business. So look out for red flags, such as where a company's debt materially exceeds that of its industry peers.

2. Concentration risk

When a large portion of the company's business is limited to a few customers, then it's prudent for it to carry less debt. Loss of an important customer will impact its revenue stream and jeopardise its capacity to service debt.

3. Start-ups and young companies

New companies with a limited track record should carry less debt. Their business models have yet to be fully tested and the reliability of their future revenue stream is often difficult to judge.

4. Debt structure (debt maturity)

The mix of long- and short-term debt employed by a company is important. Long-term assets are best funded out of equity and long-term borrowings, while working capital needs are best funded by bank overdraft and short-term borrowings.

Watch out for companies that rely heavily on the use of short-term debt, particularly those with a poor credit rating. These companies are faced with an ever-present need to keep rolling the debt over, and failure to do so could lead to failure of the business.

Maturities of borrowings should also be well spread. If the bulk of a company's borrowings fall due at a time when the availability of funds is limited (such as the recent post-GFC period), refinancing may prove difficult. With a chronological spread of maturities, the need to approach the capital markets for a large refinancing in a depressed period is reduced.

5. Debt structure (currency of debt)

Check for the currency of the debt. A company with overseas assets and/or revenue will often reduce its currency exposure by maintaining a similar level of debt in that currency. If this isn't the case, offshore borrowing is still okay if it's largely hedged/swapped back to its domestic currency. If neither is the case, then the company will likely be exposed to the risk of currency fluctuations.

6. Look out for loan covenants

A loan covenant is a clause in the lending contract requiring the borrower to refrain from doing certain things. For example, the borrower might have to maintain the ratio of total liabilities (borrowings and other liabilities) to total tangible assets at a certain percentage, say no higher than 60 per cent. It's very important that companies maintain such ratios. Even if a company is servicing its debt, the breach of such a covenant may lead to a ‘technical breach' of the contract and potential recovery action by the lender.

So look out for loan covenants, study how onerous they are, and assess the likelihood of the company breaching them.

7. The level of secured borrowings in a company's balance sheet

Check the level of security that lenders are demanding. Where risks are high, lenders tend to demand more security. This provides an indication of the risk they have attached to that company.

8. Augment your analysis with other financial ratios

The debt to equity ratio should not be relied upon to the exclusion of other metrics. There are many others that can be used to judge the appropriateness of a company's debt. One that's commonly used is the interest coverage ratio, which shows how comfortably a company can meet its interest payments:

(where EBIT is profit from ordinary activities before interest expense and income tax).

The higher the ratio, the better. But the ratio should be interpreted in a similar fashion to the debt to equity ratio. What represents an acceptable figure depends on a number of factors, including the nature of the company's business, the volatility of its revenues and the composition of its debt. However, as a guide, when an interest coverage ratio falls below two, concern should be raised.

9. The balance sheet is just a ‘snapshot in time'

A criticism of the ratio approach is that ratios are static. They are correct at just one point in time (balance date), yet we are applying them to businesses that are dynamic, since the economic factors impacting businesses are ever changing.

Undertaking a debt capacity analysis goes some way towards addressing this issue. It poses a series of ‘what if' questions. Take for example an Australian iron ore mining company. A debt capacity analysis would seek to quantify the impact on its ability to service debt under a variety of different scenarios. For example, what would happen if:

• the price of iron ore dropped 50 per cent?
• interest rates rose by 3 per cent?
• the Australian dollar appreciated by 20 per cent?
• the company's capacity to raise new equity was shut down?

10. Purchasing shares on margin

I want to finish this appendix on an important point: in an ideal world a company's debt structure should represent the optimal balance between risk and return for that company.

What then of investors who choose to buy the company's shares on margin — that is, with borrowed money? They are effectively throwing the whole risk/reward debt optimisation issue out the window, denying the judgement of the company's directors and re-establishing their own gearing level. And in the process they are dialling up the risks substantially, which is food for thought when you're next tempted to take out that margin loan to buy shares.