Bet On These 5 Low Leverage Stocks To Escape A Debt Trap

Companies often need exogenous funds to ensure smooth operations and expansion of business. These funds can be arranged through debt and equity. Here comes the concept of leverage, which is basically borrowing of funds for such purposes.

Now a company can borrow money either through debt financing or equity financing. Yet, historically, it has been witnessed that companies prefer debt financing over equity financing. This is because when a company resorts to debt financing, it takes on fixed expenses in the form of interest payments for a specific time period.

However, in case of equity financing, a shareholder not only becomes a partial owner of the company but develops a direct claim on the company’s future profits as well. So, debt financing remains the preferred option for corporates.

It is imperative to mention that debt financing remains a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in the worst-case scenario.

Since a debt-free company is rare to find, we should focus on those carrying low debt levels. Historically, several leverage ratios have been developed to measure the amount of debt a company bears. Debt-to-equity ratio is one of the most common ratios.

Analyzing Debt/Equity

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio shows improved solvency for a company.

With the Q4 reporting cycle in full swing, investors must be looking for stocks that have a history of reporting solid results. However, blindly investing in stocks displaying solid earnings growth, without considering their debt level, is not a wise move.

The Winning Strategy

Considering the aforementioned factors, it is prudent to choose stocks with a low debt-to-equity ratio to ensure steady returns.

However, an investment strategy based solely on the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.

Here are the other parameters:

Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.

Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.

Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.

Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.

Zacks Investment Research

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Written By: Zacks Investment Research