10-K Diver @10kdiver:
1/
Many people use the “Debt to Equity” ratio to tell whether a company has too much debt.
For example, if this ratio is less than 0.5, debt is “manageable”.
But if it’s over 1.5, there’s too much debt. So, the company is best avoided.
Etc.
Here’s the problem with that.
10-K Diver @10kdiver:
2/
Debt to Equity treats ALL debt the same way.
$1B that’s due 18 months from now is VERY different from the same $1B due 100 years from now.
But Debt to Equity treats them both the same.
10-K Diver @10kdiver:
3/
Likewise, $1B borrowed at 10% interest vs $1B borrowed at 0.2% interest.
As far as Debt to Equity is concerned, they’re both the same.
10-K Diver @10kdiver:
4/
Fundamentally, WHY is debt risky?
Because it creates “obligations” — interest payments, principal repayments, covenants, etc.
If the company is NOT able to meet these obligations in future, it may go belly up.
That’s the BIG risk.
10-K Diver @10kdiver:
5/
So, how should we assign a *number* to this risk?
Easy. We say:
Risk due to debt = Probability that the company is unable to meet its debt obligations.
This *probability* is the number we really want.
And Debt to Equity may not be a good substitute for it.
10-K Diver @10kdiver:
6/
If the company’s debt is only due FAR out in the future — and it’s structured so that only a small portion of it is due in any 1 year — then “risk” is LOW.
If the interest rate on the debt is LOW, then also “risk” is LOW.
Debt to Equity doesn’t consider all this.
10-K Diver @10kdiver:
7/
So, what should we use INSTEAD of Debt to Equity?
I like to do a “margin of safety” analysis.
The key idea:
Figure out the MINIMUM amount of cash the company needs to generate in future, so it can comfortably meet ALL debt obligations.
10-K Diver @10kdiver:
8/
Then ask:
- Is the company currently generating FAR more cash than this required minimum?
- And is the business stable enough that this happy state of affairs is likely to continue?
If the answer to both questions is YES, then risk may be LOW.
10-K Diver @10kdiver:
9/
For more on how to do these calculations:
10-K Diver @10kdiver:
1/
Get a cup of coffee.
This is a thread that @ruima and I wrote jointly.
In this thread, we'll help you estimate how much "margin of safety" a company has when it's loaded with debt.
Understanding this will help you avoid Evergrande-type fiascos in your own portfolio.
10-K Diver @10kdiver:
10/
For still more, we did a recent Money Concept episode about the power and perils of leverage.
Link to ~1.5 hour audio: callin.com/link/IeuxcGWxCu
10-K Diver @10kdiver:
11/
So, to summarize:
Don’t let some ratio decide whether a company has too much debt.
Reason from first principles.
What’s the *risk* created by all this debt? Is this risk comfortably manageable given the company’s cash generating power?
/End