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principles of finance a la shmoop. appropriate debt ratios. so let's start

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out this little story asking why a company would take on debt in the first [man makes presentation with white board]

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place? now let's say a company could buy a

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competitor who is struggling to survive for twenty million bucks and put that

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competitor's product onto the company sales and distribution platform and in

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the first year of owning that target take a company that was fairly breakeven

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and in year one have profits of eight million bucks. after you know firing

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everyone from the competitor company and that was just acquired. in year two the

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company that makes twelve million dollars in profit basically earning back

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all of the money it borrowed to buy that competitor. was that a good deal? well

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absolutely. and companies take on debt all the time to make what is called

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strategic accretive acquisitions just like this. they borrow money to do the

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acquisition because well they probably didn't have the cash to begin with, and

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they didn't want to use their own stock because they didn't want to suffer

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dilution in the process. the debt capital allowed the company to expand and grow

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faster than it would have had it remained unleveraged. so that begs the

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question, how much debt can a company borrow? like what's the appropriate level [cash pictured]

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and how do you even think about that question? well let's start with some

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frames that paint out companies who can and maybe should borrow a lot of money,

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and those who should not. all right well the truth is that economic cyclic ality

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determines borrowing rationale. you've probably heard of the cycle or at least

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the economic cycle or at least cyclic ality. none of those ?crickets? okay all

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right and let's go back. well most of the world's economies operate in regular

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mini boom and bust cycles. the stock market typically leads this cycle or

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said the other way around the economy lags the stock market. why? well because

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stock market prognosticators investors and other gadflies spent all day staring

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at data and talking with other gadflies about what they all see in their crystal

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balls. well they're the Canaries in the mine shaft these gadflies they try to

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look into the future because they get massively paid if they are accurate in

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their predictions by putting their or their investors money

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where their mouths are. and they look for patterns. well roughly every seven or [crystal ball says "invest now"]

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eight years we tend to have a boom and a bust cycle from 1981-82 to the late 80s

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we had a big bull market and bull economy and then the junk bond scandal

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kind of killed things or about two years market recover and then from late 1992

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until late 99 early 2000 we the greatest bull market in history, thank you very

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much Yahoo and all those people, then things blew up for about two years and

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the market bottomed late 2002 and the county and oh three and recovered it in

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two oh seven oh eight, when it blew up again big time in the mortgage crisis

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which bottom then mid oh nine and fund the markets been on a tear after that

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for a decade. better check your calendar. yeah so any blip on the radar from a

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bomb going off in the middle east to a sign of fraud to a sign of structural

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weakness like the student loan crisis, we're all nervous about these days will

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send a mini panic to the people who invest in the stock market they pull

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their money the market Falls until it reaches a level where growth investors

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have all left all the optimists are gone and the value investors have now stepped [growth investor defined]

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in because the fundamental risk reward ratio now looks favorable for a dollar

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invested today paying more than a dollar in the next no year change.

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so back to company debt levels if you are a highly cyclical company can you

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afford a lot of debt ? no absolutely not. if your only business is selling washing

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machines you're gonna have very few people upgrading in bad economies.

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they'll just repair their old ones and make them last two more years instead. in

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those bad years it's likely you go from operating profits of 20 percent to

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operating losses of like 10 percent meaning of revenues. something like that

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anyway if you then stacked a bunch of debt on top of that well you'd risk

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bankruptcy in the bad times and be well pretty much dead. click on our IP. so that

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was washing machines. highly cyclical business cannot afford a lot of debt. but [massive washing machine pictured]

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what about cable television? well most people in America would rather starve or

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at least live on ramen noodles, than have their Game of Thrones and Internet

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connectivity turned off right? so in boom times the cable industry you know

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doesn't grow much faster than it does in bad times.

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doesn't whither. and the cable industry is a non cyclical business and is appropriate

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for a lot of debt. and historically yeah the cable industry has taken on massive

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amounts of debt. so note the myriad strategic options that having access to

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debt capital affords companies. lots of great reasons to have the option of a

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bunch of debt when the great opportunities arise. all right well if

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the company has lots capital at its disposal it can build better product and

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more efficient factories, tastier treats, quicker better delivery to customers, it

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can also buy competitors cut costs, and raise prices. or saving any of those

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strategic options it can take out debt, to just buy back its own stock. that way

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when you want to scream at the idiot who's running the company the one [woman glares at self in mirror]

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responsible for selling you the friggin shares, that you just bought back, well

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you know then all you need to do is find a mirror. so all debt is not bad. all

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right well what's an appropriate debt level? yeah well there are really two

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drivers of appropriateness so when it comes to debt levels and both are framed

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in the revenue and margin structure of the company, all right backing up. the

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general idea is that you have a lot of revenue and high margins say a billion

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dollars in cash profits each year, well then can you afford a billion dollars of

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debt? almost certainly. can you afford 10 billion of debt?

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well almost certainly not. [10 billion in debt crossed out]

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