Debt — Potential Ruin
Corporations have three options for financing operations: debt, income from operations, or equity. Most companies use a bit of all three options, but some rely more on debt or equity than others. What determines a company’s stability and profitability is how it structures its balance sheet to ensure.
How good is debt for financing operations?
Miller & Modigliani (M&M), two of the most popular authors in finance, claims it does not matter whether a company uses equity or debt to finance its operations. But that is only possible in a world where there are no taxes, agent costs, and asymmetric information.
If we take tax into account, using debt to finance operations would theoretically increase the value of a company, and here’s why: interest expenses are entered against the gross income before any form of tax. Also, if the interest rate is fixed, inflation gradually eats up the debt.
However, relying a lot on debt increases the financial risk of the company, and it also reduces the company’s financial flexibility.
How should debt be measured?
Many financial experts measure debt against EBITDA — an English abbreviation for Earnings Before Interest, Taxes, Depreciation, and Amortization. Their reason for using EBITDA is that they consider it a better measurement of the company’s real income than, for example, net profit.
They also argue that depreciation and amortization are simply accounting items — not cash outlays — since the fixed assets have already been purchased and paid for.
But some experienced investors think otherwise. Charlie Munger, Warren Buffet’s business partner, calls EBITDA “bullshit earnings”. He believes, and we agree with him, that the four items (interest, taxes, depreciation, and amortization) are all essential parts of a company’s costs.
Every company with debt pays interest, and everyone pays taxes. It’s only natural to account for depreciation for fixed assets that do not last forever.
Determining an acceptable level of debt for a business
Since most companies report debt in relation to EBITDA, it’s important to have a way to gauge an acceptable level of debt for any business. Most analysts use a maximum debt ratio of around 2-3 EBITDA.
However, not businesses and industries are the same: while some companies can withstand a lot of debt, others can only withstand very little debt. But one thing you should keep in mind is this: the more cyclical a company’s business is, the more you should be very careful about the debt ratio.