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Accounting: Appropriate Debt Ratios 0 Views
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- 00:00
Accounting Allah shmoop appropriate debt ratios So what is appropriate
- 00:10
How do you determine how much a company can borrow
- 00:13
our should borrow How do you even think about the
- 00:15
question Well there's a key can versus a should here
- 00:18
So let's start with some companies that can and maybe
Full Transcript
- 00:22
should borrow a lot of money and well those who
- 00:25
should not Well you've probably heard of the cycle or
- 00:28
at least the economic cycle or at least a cyclicality
- 00:31
None of those are crickets Well let's go back Most
- 00:34
of the world's economies operating regular mini boom and bust
- 00:37
cycles The stock market typically leads the cycle or said
- 00:40
the other way around The economy lags the stockmarket Why
- 00:44
Well because stock market prognosticators investors and other gadflies spent
- 00:48
all day staring at data talking with other gadflies about
- 00:51
what they see in their crystal balls And they try
- 00:53
to look into the future because they get massively paid
- 00:56
if they are accurate in their predictions by putting their
- 00:59
investors money where their mouth czar and then they look
- 01:02
for patterns roughly every seven or eight years We have
- 01:05
a boom and bust cycle from eighty one two Well
- 01:08
of late eighties we had a big bull market and
- 01:10
then a junk bond scandal killed things for about two
- 01:13
years of market recovered and then from lightning in ninety
- 01:15
two until late ninety nine early two thousand We have
- 01:18
the greatest bull market in history And so then things
- 01:20
blew up for about two years and the market bottomed
- 01:23
Enlightened oh to wish recovered in tow seven away when
- 01:26
it blew up again with the mortgage crisis which bottomed
- 01:29
in in the middle and oh nine Some like that
- 01:31
mark It's been on a tear since then and so
- 01:33
on So when he blip on the radar from a
- 01:35
bomb going off in the Middle East to AH sign
- 01:37
of fraud in the way Wall Street accounts for things
- 01:39
to assign a structural weakness like the student loan crisis
- 01:43
that's coming we'll send a mild panic to the people
- 01:45
who invest in the stock market and take risk They
- 01:48
d risk then or pull their money The market falls
- 01:51
until it reaches a level where the growth investors have
- 01:54
all left and the value investors have all stepped in
- 01:57
because the fundamental risk reward scenario then looks favorable for
- 02:00
a dollar in today paying many more dollars over the
- 02:03
time released the next few years Okay so back to
- 02:06
debt levels How does that relate to all this Well
- 02:08
if your ah highly cyclical company like you're subject a
- 02:11
big booms and big bus can you afford a lot
- 02:14
of debt No absolutely not If your only business is
- 02:18
selling washing machines well you're going to have very few
- 02:21
people upgrading in bad economies They'll repair their old ones
- 02:26
and make them last two more years instead And in
- 02:28
those bad years it's likely to go from operating profits
- 02:31
of a twenty percent or something like that toe operating
- 02:35
losses of ten percent or something like that Anyway if
- 02:38
you then stacked a bunch of dead on top of
- 02:40
that well you'd risk bankruptcy bankruptcy in the down times
- 02:44
and be well pretty much dead Gone are ripe So
- 02:46
that was washing machines Highly cyclical business But what about
- 02:50
cable television You know like Comcast and direct TV What
- 02:54
most people in America would rather starve or at least
- 02:56
live on Ramen noodles then have their game of thrones
- 02:59
and Internet connectivity turned off So in big boom times
- 03:03
cable industry doesn't grow much faster And in bad times
- 03:06
well it doesn't really with her much either The cable
- 03:08
business is non cyclical and is appropriate for a lot
- 03:12
of debt and historically it has taken on massive amounts
- 03:16
of the stuff Why would you even want debt anyway
- 03:18
Well lots of reasons If you have lots of cash
- 03:20
capital at your disposal you Khun build better product more
- 03:24
efficient factories Taste your treats quicker better delivery of data
- 03:30
comprising you know art films to customers on the Internet
- 03:34
Well you can also buy your competitors you khun then
- 03:36
cut costs fire people and then raise prices more profit
- 03:40
to you baby or saving any of those strategic options
- 03:43
You can just buy back your own stock with a
- 03:45
lot of dead right if it's cheap Well that way
- 03:47
when you want to scream at the idiot running the
- 03:49
company the one who responsible for selling you the friggin
- 03:52
shares well then all you need to do is find
- 03:54
a mirror Okay so then what is appropriate Debt level
- 03:57
Well there really two drivers of appropriate debt levels and
- 04:01
both are framed in the revenue and margin structure of
- 04:03
company The general idea is that if you have a
- 04:05
lot of revenue and high margins I'll say a billion
- 04:08
dollars in cash profits each year Well then can you
- 04:11
afford a billion dollars of debt Yes almost certainly Can
- 04:15
you afford ten billion Well almost certainly not And note
- 04:19
that if for example you're a premium subscription Internet service
- 04:22
with a billion dollars a cash flow and no debt
- 04:25
and then you take out a loan for five billion
- 04:27
dollars and buy a competitor who at the time has
- 04:30
five hundred million in cash flow then you run things
- 04:33
better and in two years double their cash flow So
- 04:36
in five years you've paid off all the money you
- 04:38
borrowed Well then for the equity owners of the company
- 04:42
you're a freaking hero The addition of five times debt
- 04:45
to cash flow being aggressive and buying your competitors well
- 04:50
it turbocharged your equity returns such that after these risky
- 04:53
five years while the equity is probably worth some five
- 04:56
to eight times what it was worth five years ago
- 04:59
the combined company is more than double and probably four
- 05:02
times as profitable as the one before you took out
- 05:05
a loan He took the risk and bought the competitors
- 05:07
Have you not lever it up Taking all that risk
- 05:10
and consolidated your little industry to be a big one
- 05:13
Well you'd probably have done fine Maybe doubled the equity
- 05:16
value in that same time Good results But shareholders then
- 05:19
don't carry you on their shoulders at the annual convention
- 05:22
Yeah Okay So what drives debt Well you know how
- 05:25
interest is deductible from taxes right Very important concept That's
- 05:29
the reason we look att pretax cash profits rather than
- 05:33
earnings When we analyze a lot of these companies are
- 05:35
really anything else When we think about debt levels we're
- 05:37
also highly sensitive to cash earnings Since banks don't usually
- 05:42
take as interest payments a few percent depreciation of a
- 05:45
tractor smelting plant we paid for eight years ago They
- 05:49
just want cash So when we think about debt levels
- 05:51
the first place we go to figure things out is
- 05:54
the catch flow statement above the income statement Right Remember
- 05:58
who's King Yeah So cash profits then get used to
- 06:01
pay interest on a given loan Alright Example let's say
- 06:05
we're hungry to buy back a ton of our own
- 06:07
stock because we're really bullish on our next four years
- 06:09
of business And we think the market is made up
- 06:12
of a bunch of idiots who are selling our stock
- 06:15
at just ten times earnings We have no debt and
- 06:17
no cash The moment in this theoretical example of a
- 06:19
hundred million dollars a pretext cash earnings xing out depreciation
- 06:22
and amortization Our banker has told us that if we
- 06:25
borrow less than a red line amount of debt will
- 06:28
pay six percent interest Redline is code for too much
- 06:31
debt Borrow less basically is what they're telling us So
- 06:34
one big ratio we have to worry about is times
- 06:37
interest covered meaning how many times is the interest costs
- 06:41
that won't be paying covered by our cash flow So
- 06:43
let's say we borrow three times EBITDA or three hundred
- 06:46
million dollars at six percent interest Well that's eighteen million
- 06:49
dollars a year in interest costs all happily tax deductible
- 06:52
So since we pay in a thirty ish percent corporate
- 06:55
income tax all things combined that six percent feels like
- 06:58
only four point two percent What We have a hundred
- 07:01
million dollars in pre tax earnings this year at eighteen
- 07:03
million dollars of interest Well we have five point five
- 07:06
five acts interest coverage That's probably awesome and easy to
- 07:10
cover with very little risk to the lender So we'll
- 07:13
go bankrupt with only three times that Even our leverage
- 07:16
that is we have over five times the amount of
- 07:19
cash coming in each year to pay at least the
- 07:22
cash interest on the loans If you had no cash
- 07:25
and no debt on your balance sheet and you earned
- 07:27
a hundred grand a year pretax with seventy grand a
- 07:30
year after tax and you had living expenses of call
- 07:32
it forty grand so that you saved thirty thousand dollars
- 07:35
Well after everything don't you think someone would loan you
- 07:38
one hundred thousand bucks at six percent for six grand
- 07:41
a year and interest payments Well you'd likely be a
- 07:43
pretty safe bet to pay it all back Well same
- 07:46
idea here with corporate world with our even dog calculations
- 07:49
But there are ways in which this math gets dicey
- 07:52
What if we had TTO have ten billion dollars in
- 07:55
revenue toe earn that hundred million dollars I e Were
- 07:58
a one percent very low profit margin business Well if
- 08:02
this is good times and our margins get cut toe
- 08:04
half a percent Or if revenues find five percent in
- 08:08
bad times and margins turned highly negative Well then we'd
- 08:12
be sunk and pretty much bankrupt Key concept You can't
- 08:15
look at any of these numbers in a vacuum like
- 08:17
just one year You've gotta look at trends over the
- 08:20
whole economic cycle The good times the bad times Well
- 08:23
they always have to be placed in context of the
- 08:25
business being run the odds that well next year people
- 08:28
stop drinking Coca Cola or they stopped watching TV or
- 08:32
they stop downloading You know art films from the Internet
- 08:35
Well those odds are pretty low Same deal with people
- 08:38
not gassing up their cars or needing health care or
- 08:41
electricity And not surprisingly those industries tend to carry a
- 08:45
lot of debt The opposite is true for the highly
- 08:47
cyclical industries like the manufacture of semiconductors or automobiles or
- 08:51
washing machines or vanity surgery Generally speaking debt even doubt
- 08:55
Ratios of three or less are relatively safe and carry
- 08:58
relatively low interest costs to rent that money ratios over
- 09:02
seven times or generally kissing bankruptcy Unless there's some very
- 09:06
special situation involved like they're selling off a Hatin Teo
- 09:09
payoff to turns of dead or something like that So
- 09:12
why are we explaining all this Doesn't this seem like
- 09:14
data and info that was simply copied and pasted from
- 09:16
some crappy finance course We'll step back and think about
- 09:19
who accountant's work for the accounting manager inside of the
- 09:22
company more or less just works for shareholders of that
- 09:25
company Those shareholders essentially just care about the investment returns
- 09:29
on the money and efforts they've put into the company
- 09:31
So it behooves accountants to take the perspective regularly of
- 09:34
a financial investor in the company when thinking about the
- 09:37
means and methods through which they communicate the math behind
- 09:40
their decision making whether it revolves around debt Teo Avatar
- 09:43
ratios or how to assess the value of four year
- 09:46
old plastic drone housing in their inventory or how to
- 09:49
think about depreciation schedules of batteries sitting on a shelf
- 09:52
just waiting to be used So in the first example
- 09:55
we focused on the ability of the company to pay
- 09:56
the interest on the loan in cash paying down principles
- 09:59
Good thing as well that many companies with steady profits
- 10:02
tend to just leave the principal on the books and
- 10:04
used the excess cash to buy back stock or do
- 10:06
other smart financial things with the dough But if things
- 10:08
go really awry and the company has to liquidate itself
- 10:11
or sell off its parts and then get those who
- 10:13
loaned it the money their principal back plus interest well
- 10:16
then the amount of assets the company has is a
- 10:19
big deal It's also a big deal as to how
- 10:21
those assets were accounted for Like that fish tank the
- 10:24
secretary bought for twenty five grand that sits in the
- 10:27
lobby Is the company carrying it at book value of
- 10:30
twenty five grand Or did it depreciate the tank five
- 10:34
grand a year each year for four years so that
- 10:36
now the net book value is five Grand Meaning are
- 10:40
the assets of the company says it has reflective of
- 10:43
the realistic assets it could get if it had to
- 10:45
liquidate its well its assets Does the company really think
- 10:49
it'd net twenty five grand for that fish tank If
- 10:51
they sold it on eBay even if they clean off
- 10:53
the algae and you know get rid of the smell
- 10:55
anyway Should an asset liquidation be needed while the debt
- 10:57
ratio then is a biggie very sensitive Simply put there
- 11:01
are both current and long term debts and current and
- 11:04
long term assets And in a liquidation event everything is
- 11:08
on sale But an asset sell off his only one
- 11:11
half of the light that the debt ratio shines on
- 11:14
things The other half revolves around how the company is
- 11:17
capitalized Meaning did the company rely on debt or equity
- 11:20
to fund its operations and infrastructure build The big question
- 11:24
is this Does the company have a lot of debt
- 11:26
relative to shareholder equity or is it the other way
- 11:28
around This ratio is a loose litmus test for the
- 11:31
weather Enough company is properly capitalized that he has appropriate
- 11:35
debt levels to do the things that's supposed to dio
- 11:37
and generally speaking the more leverage the company is the
- 11:40
more volatile it is In good times it does better
- 11:43
In bad times it does worse versus a company with
- 11:45
lower levels of debt on the balance sheet Wow yeah
- 11:47
things can go badly when they go bad
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