Debt is a double-edged sword.
To the conservative, debt is a taboo and should be decimated.
To the adventurous, debt is an enabler that fuels growth.
So, which of the two spectrum do you belong to?
Well, if you are in the conservative camp, you may avoid investing in stocks with too much debt in their balance sheets. Maybe, you focus on companies in net cash positions as you find such a financial position (excess cash + little debt) to be financially prudent.
If you are more adventurous, you may focus on companies that are ambitious. These are usually run by boards and management teams that are growth-driven. They can be a lot more effective and efficient with capital, thus, generating better Return On Equity (ROE) to their shareholders, if their plans succeed (of course).
There are pros and cons to both sides of the camp.
One values sustainability. The other values ambition and growth.
As investors, we can strive to hit a balance between the two.
To do that, I’ll explain when debt makes and doesn’t make sense to a company. Then, I would be discussing key metrics to measure a company’s debt level. From which, you would learn how it’s possible to build a conservative portfolio which is filled with high-quality stocks which are quite savvy and prudent with employing debt.
When Debt Makes & Don’t Make Sense
Debt needs to be repaid to lenders in cash.
Imagine us working as a bank officer.
We lend money to borrowers who can repay their debt.
Such repayment ability is measured based on the borrowers’ income (cash flow). The higher the income, the more he or she can borrow. The same logic is applicable to stocks. A stock can owe $1 billion in debt. But, if it can generate $2 billion in operating cash flows per year, the stock can repay all of its debt within half-a-year (if it chooses to).
Let’s say, you owe $1 million in home mortgage. If you earn $2 million a year, do you think this $1 million debt is a big deal? Not quite because you know you can settle it in full within half-a-year if you choose to. But, if you struggle to earn income, then, you might be in financial trouble. You could be forced to sell your home if you fail to keep up with your mortgage payments.
As such, I have no issues with investing in stocks that have debt. But, this works only for stocks, which have a strong generation of operating cash flows.
Next, I would list down three methods of assessing a stock’s debt levels and discuss my take on them.
Method 1 – Debt-to-Asset Ratio
Let’s say there are two businesses that generate $20 million in net profits a year.
They have 100% cash conversion. So, their operating cash flows are $20 million a year.
Both businesses generate their profits from $100 million in total assets.
But, their differences lie in capital structure.
The first finances its business with $100 million in equity and no debt.
Thus, its debt-to-asset ratio is 0%. Its return on equity is 20%.
Debt-to-Asset Ratio
= Debt / Asset x 100%
= $0 / $100 million x 100%
= 0%
ROE
= Net Profits / Equity x 100%
= $20 million / $100 million x 100%
= 20%
The second finances its business with zero equity and $100 million in debt.
Thus, its debt-to-asset ratio is 100%. Its return on equity is infinite.
Debt-to-Asset Ratio
= Debt / Asset x 100%
= $100 million / $100 million x 100%
= 100%
ROE
= Net Profits / Equity x 100%
= $20 million / $0 x 100%
= Infinite
So, is the first business of “better quality” than the second business?
To me, both businesses are equal in terms of ability to generate profits and cash flows.
But since the second business has zero equity in it, it is more capital efficient, thus, smarter.
Think of it this way.
Imagine you own a home that is valued at $1.0 million. You owe $200,000 in mortgage on it. So, your equity is $800,000. In this sense, your debt-to-asset ratio is 20%. Since you reside in your home, you earn no income from it.
Debt-to-Asset Ratio
= Debt / Asset x 100%
= $200,000 / $1,000,000 x 100%
= 20%
Now, what if you cash out $300,000 via refinancing?
From it, you buy a $300,000 investment property and earn net rental income of $500 a month.
Now, you own two properties worth $1.3 million and owe $500,000 in mortgage. You still retain your $800,000 in equity.
Sure, your debt-to-asset ratio increases to 38%.
But from it, you make an additional $500 a month in income.
Debt-to-Asset Ratio
= Debt / Asset x 100%
= $500,000 / $1,300,000 x 100%
= 38%
That’s capital efficiency as you have created more income with debt.
Because of this, I put less emphasis on debt-to-asset ratio in assessing a stock’s debt level.
Method 2 – Interest Coverage
Interest coverage is calculated with the formula below:
Interest Coverage
= Earnings before interest & taxes (EBIT) / Interest Expense
Let’s say, there are two businesses. The first owes $1 billion. The second owes $2 billion.
The first generates $60 million in EBIT a year and pays an interest of $30 million a year. Thus, its interest coverage is 2.0.
Interest Coverage
= Earnings before interest & taxes (EBIT) / Interest Expense
= $60 million / $30 million
= 2.0
The second generates $600 million in EBIT a year and pays an interest of $60 million a year. The interest coverage for this business is 10.0.
Interest Coverage
= Earnings before interest & taxes (EBIT) / Interest Expense
= $600 million / $60 million
= 10.0
In this sense, despite having more debt and paying more interest cost, the second business, which generates $600 million in EBIT, is more conservative with debt as its interest coverage is a lot higher than the first business.
It is likened to one who earns $10,000 a month and pays $1,000 in interest costs.
Can you imagine one who earns $20,000 a month and pays $10,000 in interest costs? That will be quite stressful.
Personally, I prefer this method of assessing a stock’s debt level.
Method 3 – Debt-to-Operating Cash Flows
While it’s not written in accounting books, this is my favourite way of assessing debt levels.
Sure, interest cover is good.
This works only if the company has high cash conversion.
As for debt-to-operating cash flows, this is an ironclad guarantee that it compares its debt with cash flows.
For instance, there are two businesses. The first owes $1 billion. The second owes $2 billion.
The first business brings in $50 million in operating cash flows a year. Thus, it has the capability of paying off its debt in 20 years (assuming all cash flows brought in are used to pay debt).
Debt-to-Operating Cash Flows
= Debt / Operating Cash Flows
= $1 billion / $50 million
= 20 years
The second business brings in $1 billion in operating cash flows a year. Thus, it is able to clear all its debt in 2 years.
Debt-to-Operating Cash Flows
= Debt / Operating Cash Flows
= $2 billion / $1 billion
= 2 years
So, despite the fact that the second business owes more debt, it has the ability to pay off them faster.
Hence, the second business is more conservative in debt.
Conclusion
The key to assessing debt is not based on its quantum but based on the company’s capability in settling them with business profits and operating cash flows.
To end this, here is a quick checklist that allows you to quickly assess a stock’s debt level:
1. Interest Coverage: The Higher, the More Conservative
2. Debt-to-Operating Cash Flows: The Lower, the More Conservative
Often, if you find companies with high interest coverage and low debt-to-operating cash flows, these are profitable cash cows that manage debt prudently.
Ultimately, if debt is well-managed, it can be a powerful tool that accelerates stock returns.
