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The Debt Problem

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The Debt Problem

Trying to identify just how indebted a company is, has become a major challenge for investors.

On any company’s balance sheet, the amount of money it owes to its creditors is one of the most important figures. The money that a company owes to someone has an impact on loads of factors, including solvency risk, credit rating, trade sensitivity, exposure to foreign currency, repayment issues, and profitability.

A majority of businesses that went under during the pandemic did so because of excessive debt. Debt is a really important factor for investors to consider. Unfortunately, investors often have a hard time finding crucial details about a company’s indebtedness.

Loan Covenants

Companies are obligated to disclose their loan covenants to anyone. Most companies refuse to share this information for “commercial confidentiality”; however, this excuse doesn’t work well once someone looks into it. Distressed companies have a hard time doing business, but there’s never been an instance of a healthy company nearing covenant breach. In most cases, it’s unhealthy companies that get close to breaching covenants.

Investors and creditors only feel the need to ask about a company’s covenants when it has become obvious that the company is undergoing stress. When companies refuse to disclose their covenants even with their distress being apparent, things get even worse.

Along with a lack of information regarding company covenants, investors have a hard time finding information on a company’s effective currency.

Other Factors

Not having adequate information on a company’s effective currency and covenants is bad enough for investors, but there are loads of other things as well that make the situation even more undesirable. A lot of companies have an ownership of 51-90% of stakes in important subsidiaries. A portion of ownership usually belongs to a party that does not require disclosure. This holds true for majority-owned cash as well. Due to this, the effective rate often becomes murky.

Advance payments add an additional layer of complexity to the debt problem. Companies that take advance payments against goods or services that they have not yet delivered (effectively making these payments a sort of loan) note these advances as cash.

Companies that operate in the captive financing industry, such as car leasing companies, are hard to figure out as well. Debts taken by these companies are backed by assets, meaning that interest on these debts is paid by the lessee. This leads to the argument that leasing debt isn’t the shareholders’ liability. In reality, leasing debt is hard to trace if a company does not voluntarily disclose it.

Lagging Standards

The IFRS’ amendment 7 should have provided a solution for this problem. Loopholes and vague wording in the amendment have given companies liberty in keeping their debt situation fuzzy and hard to figure out. The best solution to this problem right now is to encourage companies to adopt better practices for voluntary disclosure.

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