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Accounting Allah shmoop appropriate debt ratios So what is appropriate

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How do you determine how much a company can borrow

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our should borrow How do you even think about the

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question Well there's a key can versus a should here

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So let's start with some companies that can and maybe

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should borrow a lot of money and well those who

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

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at least the economic cycle or at least a cyclicality

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

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

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cycles The stock market typically leads the cycle or said

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the other way around The economy lags the stockmarket Why

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Well because stock market prognosticators investors and other gadflies spent

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all day staring at data talking with other gadflies about

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what they see in their crystal balls And they try

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to look into the future because they get massively paid

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if they are accurate in their predictions by putting their

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investors money where their mouth czar and then they look

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for patterns roughly every seven or eight years We have

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a boom and bust cycle from eighty one two Well

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of late eighties we had a big bull market and

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then a junk bond scandal killed things for about two

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years of market recovered and then from lightning in ninety

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two until late ninety nine early two thousand We have

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the greatest bull market in history And so then things

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blew up for about two years and the market bottomed

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Enlightened oh to wish recovered in tow seven away when

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it blew up again with the mortgage crisis which bottomed

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in in the middle and oh nine Some like that

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

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on So when he blip on the radar from a

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bomb going off in the Middle East to AH sign

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of fraud in the way Wall Street accounts for things

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to assign a structural weakness like the student loan crisis

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

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who invest in the stock market and take risk They

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d risk then or pull their money The market falls

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until it reaches a level where the growth investors have

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all left and the value investors have all stepped in

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because the fundamental risk reward scenario then looks favorable for

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a dollar in today paying many more dollars over the

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time released the next few years Okay so back to

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debt levels How does that relate to all this Well

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

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big booms and big bus can you afford a lot

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of debt No absolutely not If your only business is

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

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

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and make them last two more years instead And in

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

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of a twenty percent or something like that toe operating

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losses of ten percent or something like that Anyway if

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you then stacked a bunch of dead on top of

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

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and be well pretty much dead Gone are ripe So

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that was washing machines Highly cyclical business But what about

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cable television You know like Comcast and direct TV What

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most people in America would rather starve or at least

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live on Ramen noodles then have their game of thrones

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and Internet connectivity turned off So in big boom times

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

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

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business is non cyclical and is appropriate for a lot

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of debt and historically it has taken on massive amounts

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of the stuff Why would you even want debt anyway

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Well lots of reasons If you have lots of cash

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capital at your disposal you Khun build better product more

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efficient factories Taste your treats quicker better delivery of data

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comprising you know art films to customers on the Internet

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Well you can also buy your competitors you khun then

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cut costs fire people and then raise prices more profit

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to you baby or saving any of those strategic options

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You can just buy back your own stock with a

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

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when you want to scream at the idiot running the

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company the one who responsible for selling you the friggin

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shares well then all you need to do is find

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a mirror Okay so then what is appropriate Debt level

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Well there really two drivers of appropriate debt levels and

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both are framed in the revenue and margin structure of

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company The general idea is that if you have a

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

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dollars in cash profits each year Well then can you

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afford a billion dollars of debt Yes almost certainly Can

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you afford ten billion Well almost certainly not And note

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

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with a billion dollars a cash flow and no debt

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and then you take out a loan for five billion

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dollars and buy a competitor who at the time has

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five hundred million in cash flow then you run things

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better and in two years double their cash flow So

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

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borrowed Well then for the equity owners of the company

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

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to cash flow being aggressive and buying your competitors well

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it turbocharged your equity returns such that after these risky

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five years while the equity is probably worth some five

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to eight times what it was worth five years ago

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the combined company is more than double and probably four

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times as profitable as the one before you took out

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a loan He took the risk and bought the competitors

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Have you not lever it up Taking all that risk

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and consolidated your little industry to be a big one

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

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value in that same time Good results But shareholders then

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

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Yeah Okay So what drives debt Well you know how

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

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the reason we look att pretax cash profits rather than

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earnings When we analyze a lot of these companies are

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

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

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take as interest payments a few percent depreciation of a

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tractor smelting plant we paid for eight years ago They

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just want cash So when we think about debt levels

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the first place we go to figure things out is

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the catch flow statement above the income statement Right Remember

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

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

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

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

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of business And we think the market is made up

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of a bunch of idiots who are selling our stock

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at just ten times earnings We have no debt and

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no cash The moment in this theoretical example of a

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hundred million dollars a pretext cash earnings xing out depreciation

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and amortization Our banker has told us that if we

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borrow less than a red line amount of debt will

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pay six percent interest Redline is code for too much

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

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one big ratio we have to worry about is times

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interest covered meaning how many times is the interest costs

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

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

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

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dollars a year in interest costs all happily tax deductible

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So since we pay in a thirty ish percent corporate

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income tax all things combined that six percent feels like

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only four point two percent What We have a hundred

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million dollars in pre tax earnings this year at eighteen

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million dollars of interest Well we have five point five

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

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

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go bankrupt with only three times that Even our leverage

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that is we have over five times the amount of

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cash coming in each year to pay at least the

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cash interest on the loans If you had no cash

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and no debt on your balance sheet and you earned

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a hundred grand a year pretax with seventy grand a

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year after tax and you had living expenses of call

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it forty grand so that you saved thirty thousand dollars

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

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one hundred thousand bucks at six percent for six grand

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

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pretty safe bet to pay it all back Well same

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idea here with corporate world with our even dog calculations

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But there are ways in which this math gets dicey

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What if we had TTO have ten billion dollars in

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revenue toe earn that hundred million dollars I e Were

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a one percent very low profit margin business Well if

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this is good times and our margins get cut toe

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half a percent Or if revenues find five percent in

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

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

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look at any of these numbers in a vacuum like

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

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whole economic cycle The good times the bad times Well

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they always have to be placed in context of the

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business being run the odds that well next year people

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stop drinking Coca Cola or they stopped watching TV or

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they stop downloading You know art films from the Internet

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Well those odds are pretty low Same deal with people

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not gassing up their cars or needing health care or

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electricity And not surprisingly those industries tend to carry a

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lot of debt The opposite is true for the highly

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cyclical industries like the manufacture of semiconductors or automobiles or

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washing machines or vanity surgery Generally speaking debt even doubt

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Ratios of three or less are relatively safe and carry

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relatively low interest costs to rent that money ratios over

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

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

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payoff to turns of dead or something like that So

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

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data and info that was simply copied and pasted from

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

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

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company more or less just works for shareholders of that

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company Those shareholders essentially just care about the investment returns

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

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So it behooves accountants to take the perspective regularly of

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a financial investor in the company when thinking about the

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means and methods through which they communicate the math behind

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their decision making whether it revolves around debt Teo Avatar

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ratios or how to assess the value of four year

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old plastic drone housing in their inventory or how to

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think about depreciation schedules of batteries sitting on a shelf

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just waiting to be used So in the first example

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we focused on the ability of the company to pay

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the interest on the loan in cash paying down principles

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Good thing as well that many companies with steady profits

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tend to just leave the principal on the books and

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used the excess cash to buy back stock or do

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other smart financial things with the dough But if things

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go really awry and the company has to liquidate itself

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or sell off its parts and then get those who

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loaned it the money their principal back plus interest well

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then the amount of assets the company has is a

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

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those assets were accounted for Like that fish tank the

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secretary bought for twenty five grand that sits in the

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lobby Is the company carrying it at book value of

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twenty five grand Or did it depreciate the tank five

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grand a year each year for four years so that

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now the net book value is five Grand Meaning are

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the assets of the company says it has reflective of

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the realistic assets it could get if it had to

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liquidate its well its assets Does the company really think

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

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they sold it on eBay even if they clean off

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the algae and you know get rid of the smell

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anyway Should an asset liquidation be needed while the debt

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ratio then is a biggie very sensitive Simply put there

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are both current and long term debts and current and

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long term assets And in a liquidation event everything is

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on sale But an asset sell off his only one

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half of the light that the debt ratio shines on

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things The other half revolves around how the company is

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capitalized Meaning did the company rely on debt or equity

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to fund its operations and infrastructure build The big question

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is this Does the company have a lot of debt

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relative to shareholder equity or is it the other way

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around This ratio is a loose litmus test for the

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weather Enough company is properly capitalized that he has appropriate

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

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and generally speaking the more leverage the company is the

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more volatile it is In good times it does better

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In bad times it does worse versus a company with

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lower levels of debt on the balance sheet Wow yeah

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things can go badly when they go bad

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