by elmads

Introduction

A couple of years ago, I was doing my own study about the 2008 financial global financial crisis. A lot of things happened during that time, and It was incomprehensible how the real estate and banking industry let that bubble happen. It was all human error, or shall I say greed, in the process that caused such catastrophe. This crisis resulted for small to large sized businesses to close, and even a certain top US bank collapsed that time, the bank’s name was “Lehman Brothers”.

I became very curious with what transpired back then, so I did some of my research to as what happened with Lehman Brothers, and somehow I found skeletons inside their financial statements and even with their investment allocations during that time. Lehman Brothers was deeply ingrained in this problem, what made it worse is that they went into large sums of debt and used it to purchase financially engineered assets (included here was the Mortgage Backed Securities), which by the way was one of the reasons why the crisis occurred.

Lehman Brothers’ amount of debt was so high that it reached 6x relative to its equity before the collapse. It was insanely elevated that the business couldn’t handle it anymore during the boiling point of the crisis. Plus, they used that debt capital to invest in bad assets.

High debt while using that debt to purchase very high risky assets + economic crisis = DISASTER.

This is the reason why in investing, looking into the management of a company, their debt and liquidity levels, and how they manage it, is an important part of fundamental analysis. In totality, it is looking into a company’s balance sheet, is it a financial fortress or a financial disaster?

Why do Companies use Debt?

Companies need capital in order to expand their business operations. They do it in two ways, through equity financing (giving small pieces of their company to investors in exchange for monies) and through Debt financing (borrowing money from investors). Both have their pros and cons, and depending where the company is at in their corporate life cycle, (introduction, growth, maturity and decline stages) we would be able to assess the risk and reward it can bring upon to its business.

Debt financing has its advantages, firstly, the company would not need to dilute the current amount of shares of their business via Equity Financing, and the other is with taxes. Acquiring debt reduces the amount corporations pay in tax. This is a strategy used by most companies via tax interest and related cost deductions.

Basically, the interest payment they pay with their debt can be declared as a tax deductibles to their Operating Income. That’s why we can see on the income statement that the interest payments will be deducted first to their earnings, while the tax deduction will be the last. See chart below;

I used Apple Incorporation’s 2020 income statement report as an example. As shown above, their total interest debt payments will be deducted fist on their Operating Income, before the tax gets deducted. Whereas, the reverse happens with an individual’s personal income, where taxes are immediately deducted first from the gross income line.

This is also the reason why some companies still get debt despite not purely needing it. This for the purpose of reducing the corporate tax that they will pay, hence for a lower net income for the company. Why? because the reduction in net income also represents a tax benefit through the lower taxable income.

Nonetheless, debt is and will always be a double edge sword. It could cause financial problems or insolvency of the company if not properly financially analyzed, and handled by the management. As an investor it is our job to see if the company we want to invest, or are currently invested have good financial liquidity to pay their debts via several metrics which I will tackle in this blog.

PS: all ratios are based on a company’s balanced sheet. I have made a blog titled “The Balance Sheet”, where I wrote about the basic information of each line of the balance sheet.

Current Ratio (Liquidity Metric)

This is one of the most used metrics when looking into a company’s liquidity. It is called the Current Ratio, because it looks on the current assets and the current liabilities of a business.

To quickly define the difference between current assets and current liabilities. Current assets are assets that can be easily and quickly made into cash like cash itself, money market instruments, inventories of a company and more. Whereas, current liabilities are liabilities that needs to be paid within a year, such as lease payments and accounts payable (money owed to suppliers).

• Formula;

Current Ratio = Current Assets / Current Liabilities

A good current ratio should be more than 1.0, while 2.0 and above is a wonderful number. The higher the current ratio is, the better.

The Current Ratio indicates if the company has enough current assets to pay all of their current liabilities. In personal finance, it is like our emergency fund plus savings relative to our debts (that are due to be paid within the year) plus our current year’s worth of expenses. The higher it is the better, because if problems occur like getting laid off from work, my question then is this, will we be able to sustain a few months of our lives without income? this is exactly the same for companies. Will the company be able to pay for their short-term financial responsibilities with the current assets they have? even if they will not be able to generate any income from their business within a year due to unforeseen events?

To make this clearer, we’ll take 3 companies as an example with their corresponding 2021 Current Ratios. All information was taken and computed from their respective 2021 annual reports.

• Tesla Motors (US) – Current Ratio 1.37 = Current Assets $27,100 / Current Liabilities $19,705
• Astrazeneca Pharmaceuticals (UK) – Current Ratio 1.16 = Current Assets £26,244 / Current Liabilities £22,594
• Ayala Corporation (Philippines) – Current Ratio 1.85 = Current Assets ₱497,272 / Current Liabilities ₱268,094

The three businesses cited above have current ratios above 1, which means that their current assets can fully cover their current liabilities.

Take note: the current ratio is just one metric of a lot of liquidity metrics. This must not be the only metric that will dictate your investment decision.

Debt-to-Equity Ratio (Debt Metric)

This metric is used to compare a company’s debt to its total equity. In personal finance, this is the ratio of your Debt to your total Net Worth.

For us to understand this metric, we firstly need to understand what is equity. Equity is the amount of money owned by the shareholders of the company. Computing this is easy, we just need to get the company’s Total Assets then subtract it from its Total Liabilities. This can be found on a company’s yearly updated Balance Sheet of their annual reports.

It’s just like our individual net worth, in which we get it by subtracting our total assets to our total liabilities.

Equity is the monetary value of the company, and also the amount of money of what investors/shareholders own in the business.

Once we get the equity, we move forward to debt. To look for a company’s debt, we would need to see their Balance Sheet. Every company has different ways into showing their debts, but usually it can be seen in three ways.

1^st – in the current liabilities section, then in row stated as current portion of long-term debts.

2^nd – in the non-current liabilities section, long-term debts or just debts.

3^rd – in the non-current liabilities section, capital leases (it is actually the property monthly payment expenses, but it is also considered debt to be paid as it depreciates overtime and incurs interests.)

Add all of it together, and we arrive into the total debt of the company.

To arrive to the company’s Debt-to-Equity, we just divide the total debt of the business to its Equity;

• Formula:

Debt-to-Equity = Total Debt / Total Equity

We’ll compute Apple Inc’s 2020 Debt-to-Equity

The total Debt of Apple Inc. for year 2020 was $109.51 Billion. I got it by adding the encircled numbers in the photo above. While the Total Equity is $78.43 Billion.

NOTE: Commercial Paper and Repurchase Agreement are debts of different sort.

• Debt-to Equity = ($109.51 / $78.43)*100
• Apple’s Debt-to-Equity is = 140%

This means that Apple has more debt than the total amount of money of all of their shareholders and investors. But, this doesn’t automatically mean that Apple is a bad investment, again one metric doesn’t completely show the whole story of the business within a fiscal year.

There is no perfect level for Debt-to-Equity, but it has been said that the acceptable amount would be less than 100%. Whereas, in Warren Buffett’s point of view, he prefers companies to only posses less than 50% of Debt-to-Equity.

Having a low Debt-to-Equity ratio is very important for a company, as it helps them survive any financial storms that may come. May it be from a wider macroeconomic crisis, a specific sector/industry crisis or to a microlevel dilemma like business operational problems.

Insolvency may occur to businesses when they are not able to . . .

Insolvency usually happens to businesses when they are not able to service their debts anymore, their inability to pay their creditors, and their other financial responsibilities like paying for their suppliers.

When a business’ top line and bottom line earnings either have stalled or keeps on declining, has poor liquidity and high debt levels, where do you think will such business get the money to be able to service their debts and other financial responsibilities? for most businesses in this financial situation, their only way out is filling for bankruptcy.

This is what happened to Lehman Brothers in 2008, their debt to equity ratio was more than 600%, then the crisis happens. They were not able to pay anymore their debt and got squeezed by their financial responsibilities. A company could survive having a lot of debt for a long time but when the shit hits the fan, most of these highly leveraged companies either go into bankruptcy or are hanging dearly with their own business lives. I’ve discussed the types of bankruptcies before, see my blog titled “Bankruptcy in the US”

While the collapse of Lehman Brothers brought most of the financial industry and the economy unto its knees, there was another bank who took the spotlight during the turmoil. This was J.P. Morgan and Chase with its reigning CEO for 16 years and counting, Jamie Dimon. A year before the 2007-2008 Financial Crisis started, (2006) a young Jamie Dimon took the seat as the newly appointed CEO of J.P. Morgan & Chase. The immediate actions he took as the new CEO was to strengthen JPM’s balance sheet as a bank, he cut costs, removed all unnecessary expenses on its business operations, reduced the number of their employees, sold the not needed assets and unproductive assets, and most importantly evaluated all of the bank’s loan portfolio.

When the crisis hit after a year or two, JPM was the only bank who didn’t have exposure to Mortgage Backed Securities (MBS). Plus, they had one of the strongest, if not the strongest balance sheet in the banking industry during the financial/housing crisis of 2008.

After the said economic crisis J.P. Morgan & Chase came out unscathed, and secured a seat on the round table of the Top 3 banks in the US. This was all thanks to Jamie Dimon, who built a strong balance sheet, possessing high liquidity, good Cash balance, low Debt-to-Equity and most of all not holding high risky assets.

To Sum It Up

The debt metric ratios of a company, in a specified year is not yet the full story of it. We must also look into the past debt ratios and see what happened to that debt, where did they use it, did they reinvest it, or paid it as dividends or just an added capital support via cash. We need to know the full story, if the debt was used as a good income generating debt or was it mismanaged?

Debt is relative per industry, technology companies usually have low debts because they are high income generating industry, who mostly do not require to much capital for maintenance expenditures and operating expenses.

On the flipside, companies in the telecommunication industry have higher debts compared to other industries because of the continuous capital needed for maintenance expenditures and investment capital expenditures like for building more communication towers. Henceforth, the need to acquire debt.

Don’t just look into the face value of the debt metrics, it is always prudent to look deeper, how a company use their debt, if it is manageable or not.

That being said, it is always safe to say that, companies who have less debts will always do best regardless if the economy is in a great shape or not. Also, having a low to no debt, gives more predictability of the company’s future outlook in terms of cash flows. Just like what Warren Buffet has said.

“I do not like debt and do not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.”

Warren Buffett

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.