Accounting: Appropriate Debt Ratios

should borrow a lot of money and well those who

should not Well you've probably heard of the cycle or

at least the economic cycle or at least a cyclicality

None of those are crickets Well let's go back Most

of the world's economies operating regular mini boom and bust

cycles The stock market typically leads the cycle or said

the other way around The economy lags the stockmarket Why

Well because stock market prognosticators investors and other gadflies spent

all day staring at data talking with other gadflies about

what they see in their crystal balls And they try

to look into the future because they get massively paid

if they are accurate in their predictions by putting their

investors money where their mouth czar and then they look

for patterns roughly every seven or eight years We have

a boom and bust cycle from eighty one two Well

of late eighties we had a big bull market and

then a junk bond scandal killed things for about two

years of market recovered and then from lightning in ninety

two until late ninety nine early two thousand We have

the greatest bull market in history And so then things

blew up for about two years and the market bottomed

Enlightened oh to wish recovered in tow seven away when

it blew up again with the mortgage crisis which bottomed

in in the middle and oh nine Some like that

mark It's been on a tear since then and so

on So when he blip on the radar from a

bomb going off in the Middle East to AH sign

of fraud in the way Wall Street accounts for things

to assign a structural weakness like the student loan crisis

that's coming we'll send a mild panic to the people

who invest in the stock market and take risk They

d risk then or pull their money The market falls

until it reaches a level where the growth investors have

all left and the value investors have all stepped in

because the fundamental risk reward scenario then looks favorable for

a dollar in today paying many more dollars over the

time released the next few years Okay so back to

debt levels How does that relate to all this Well

if your ah highly cyclical company like you're subject a

big booms and big bus can you afford a lot

of debt No absolutely not If your only business is

selling washing machines well you're going to have very few

people upgrading in bad economies They'll repair their old ones

and make them last two more years instead And in

those bad years it's likely to go from operating profits

of a twenty percent or something like that toe operating

losses of ten percent or something like that Anyway if

you then stacked a bunch of dead on top of

that well you'd risk bankruptcy bankruptcy in the down times

and be well pretty much dead Gone are ripe So

that was washing machines Highly cyclical business But what about

cable television You know like Comcast and direct TV What

most people in America would rather starve or at least

live on Ramen noodles then have their game of thrones

and Internet connectivity turned off So in big boom times

cable industry doesn't grow much faster And in bad times

well it doesn't really with her much either The cable

business is non cyclical and is appropriate for a lot

of debt and historically it has taken on massive amounts

of the stuff Why would you even want debt anyway

Well lots of reasons If you have lots of cash

capital at your disposal you Khun build better product more

efficient factories Taste your treats quicker better delivery of data

comprising you know art films to customers on the Internet

Well you can also buy your competitors you khun then

cut costs fire people and then raise prices more profit

to you baby or saving any of those strategic options

You can just buy back your own stock with a

lot of dead right if it's cheap Well that way

when you want to scream at the idiot running the

company the one who responsible for selling you the friggin

shares well then all you need to do is find

a mirror Okay so then what is appropriate Debt level

Well there really two drivers of appropriate debt levels and

both are framed in the revenue and margin structure of

company The general idea is that if you have a

lot of revenue and high margins I'll say a billion

dollars in cash profits each year Well then can you

afford a billion dollars of debt Yes almost certainly Can

you afford ten billion Well almost certainly not And note

that if for example you're a premium subscription Internet service

with a billion dollars a cash flow and no debt

and then you take out a loan for five billion

dollars and buy a competitor who at the time has

five hundred million in cash flow then you run things

better and in two years double their cash flow So

in five years you've paid off all the money you

borrowed Well then for the equity owners of the company

you're a freaking hero The addition of five times debt

to cash flow being aggressive and buying your competitors well

it turbocharged your equity returns such that after these risky

five years while the equity is probably worth some five

to eight times what it was worth five years ago

the combined company is more than double and probably four

times as profitable as the one before you took out

a loan He took the risk and bought the competitors

Have you not lever it up Taking all that risk

and consolidated your little industry to be a big one

Well you'd probably have done fine Maybe doubled the equity

value in that same time Good results But shareholders then

don't carry you on their shoulders at the annual convention

Yeah Okay So what drives debt Well you know how

interest is deductible from taxes right Very important concept That's

the reason we look att pretax cash profits rather than

earnings When we analyze a lot of these companies are

really anything else When we think about debt levels we're

also highly sensitive to cash earnings Since banks don't usually

take as interest payments a few percent depreciation of a

tractor smelting plant we paid for eight years ago They

just want cash So when we think about debt levels

the first place we go to figure things out is

the catch flow statement above the income statement Right Remember

who's King Yeah So cash profits then get used to

pay interest on a given loan Alright Example let's say

we're hungry to buy back a ton of our own

stock because we're really bullish on our next four years

of business And we think the market is made up

of a bunch of idiots who are selling our stock

at just ten times earnings We have no debt and

no cash The moment in this theoretical example of a

hundred million dollars a pretext cash earnings xing out depreciation

and amortization Our banker has told us that if we

borrow less than a red line amount of debt will

pay six percent interest Redline is code for too much

debt Borrow less basically is what they're telling us So

one big ratio we have to worry about is times

interest covered meaning how many times is the interest costs

that won't be paying covered by our cash flow So

let's say we borrow three times EBITDA or three hundred

million dollars at six percent interest Well that's eighteen million

dollars a year in interest costs all happily tax deductible

So since we pay in a thirty ish percent corporate

income tax all things combined that six percent feels like

only four point two percent What We have a hundred

million dollars in pre tax earnings this year at eighteen

million dollars of interest Well we have five point five

five acts interest coverage That's probably awesome and easy to

cover with very little risk to the lender So we'll

go bankrupt with only three times that Even our leverage

that is we have over five times the amount of

cash coming in each year to pay at least the

cash interest on the loans If you had no cash

and no debt on your balance sheet and you earned

a hundred grand a year pretax with seventy grand a

year after tax and you had living expenses of call

it forty grand so that you saved thirty thousand dollars

Well after everything don't you think someone would loan you

one hundred thousand bucks at six percent for six grand

a year and interest payments Well you'd likely be a

pretty safe bet to pay it all back Well same

idea here with corporate world with our even dog calculations

But there are ways in which this math gets dicey

What if we had TTO have ten billion dollars in

revenue toe earn that hundred million dollars I e Were

a one percent very low profit margin business Well if

this is good times and our margins get cut toe

half a percent Or if revenues find five percent in

bad times and margins turned highly negative Well then we'd

be sunk and pretty much bankrupt Key concept You can't

look at any of these numbers in a vacuum like

just one year You've gotta look at trends over the

whole economic cycle The good times the bad times Well

they always have to be placed in context of the

business being run the odds that well next year people

stop drinking Coca Cola or they stopped watching TV or

they stop downloading You know art films from the Internet

Well those odds are pretty low Same deal with people

not gassing up their cars or needing health care or

electricity And not surprisingly those industries tend to carry a

lot of debt The opposite is true for the highly

cyclical industries like the manufacture of semiconductors or automobiles or

washing machines or vanity surgery Generally speaking debt even doubt

Ratios of three or less are relatively safe and carry

relatively low interest costs to rent that money ratios over

seven times or generally kissing bankruptcy Unless there's some very

special situation involved like they're selling off a Hatin Teo

payoff to turns of dead or something like that So

why are we explaining all this Doesn't this seem like

data and info that was simply copied and pasted from

some crappy finance course We'll step back and think about

who accountant's work for the accounting manager inside of the

company more or less just works for shareholders of that

company Those shareholders essentially just care about the investment returns

on the money and efforts they've put into the company

So it behooves accountants to take the perspective regularly of

a financial investor in the company when thinking about the

means and methods through which they communicate the math behind

their decision making whether it revolves around debt Teo Avatar

ratios or how to assess the value of four year

old plastic drone housing in their inventory or how to

think about depreciation schedules of batteries sitting on a shelf

just waiting to be used So in the first example

we focused on the ability of the company to pay

the interest on the loan in cash paying down principles

Good thing as well that many companies with steady profits

tend to just leave the principal on the books and

used the excess cash to buy back stock or do

other smart financial things with the dough But if things

go really awry and the company has to liquidate itself

or sell off its parts and then get those who

loaned it the money their principal back plus interest well

then the amount of assets the company has is a

big deal It's also a big deal as to how

those assets were accounted for Like that fish tank the

secretary bought for twenty five grand that sits in the

lobby Is the company carrying it at book value of

twenty five grand Or did it depreciate the tank five

grand a year each year for four years so that

now the net book value is five Grand Meaning are

the assets of the company says it has reflective of

the realistic assets it could get if it had to

liquidate its well its assets Does the company really think

it'd net twenty five grand for that fish tank If

they sold it on eBay even if they clean off

the algae and you know get rid of the smell

anyway Should an asset liquidation be needed while the debt

ratio then is a biggie very sensitive Simply put there

are both current and long term debts and current and

long term assets And in a liquidation event everything is

on sale But an asset sell off his only one

half of the light that the debt ratio shines on

things The other half revolves around how the company is

capitalized Meaning did the company rely on debt or equity

to fund its operations and infrastructure build The big question

is this Does the company have a lot of debt

relative to shareholder equity or is it the other way

around This ratio is a loose litmus test for the

weather Enough company is properly capitalized that he has appropriate

debt levels to do the things that's supposed to dio

and generally speaking the more leverage the company is the

more volatile it is In good times it does better

In bad times it does worse versus a company with

lower levels of debt on the balance sheet Wow yeah

things can go badly when they go bad