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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

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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