"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 (Trades, Portfolio)
A high level of debt can be one of the most obvious red flags when it comes to evaluating companies. It can signify many different things, but the overriding consequence is a lack of financial flexibility.
The restrictions of borrowing
A company with no borrowing has more freedom to do it wants, as it does not have to appease creditors. A business with a high level of borrowing, on the other hand, can become a slave to creditors. In the worst-case scenario, the company's creditors can take over the enterprise if it becomes abundantly clear that the company is at risk of not being able to meet its repayment obligations.
As the above the quote above from Buffett explains, a high level of long-term debt can make it difficult to calculate a company's intrinsic value. Investors cannot place a future value on cash flows if the cash flows are highly uncertain. High debt repayment costs can make it challenging to forecast future cash flows.
How much is too much?
On the other hand, borrowing funds is often essential in order to get the business off the ground in the first place or grow at a profitable pace. The question is, how much debt is too much?
Some companies have successfully deployed large amounts of debt to improve returns. Others have not. Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has issued nearly $10 billion of Yen-denominated debt in recent years, with maturities stretching out to 40 years. The rate the conglomerate is paying on this 40-year debt was pegged at 2% at the time of the issue. Clearly, even Buffett has times where he believes taking on debt is a profitable endeavor, though investors should note Buffett's firm is able to secure more favorable deals due to its scale advantage.
Unfortunately, there's never going to be a definitive answer to the question of how much debt is too much. The answer to this question will vary depending on the company, sector, industry and economic environment, as well as the individual or company taking on the debt.
For example, a utility company may be able to borrow more than average. The balance sheets of these companies tend to be high in tangible assets with stable cash flows, which creditors are happy to lend against. However, as we saw with PG&E Corp. (PGE, Financial), even utility companies can be thrown off course by a significant risk event such as refusing to update their equipment for so long that a widespread disaster is caused.
In the avove situation, hedge funds grabbed control of the business by acquiring debt claims from other creditors. PG&E is a perfect example of how creditors can take over a business when it becomes too reliant on debt (and PG&E didn't even use the debt to improve its business in the first place).
When a business (or person for that matter) relies too much on debt, there's always going to be the risk that thier creditors will desert them. It is important to keep in mind that creditors are never the friend of the borrower - they are also in the deal to make a profit.
The ability to roll over debt
Some of the biggest financial disasters of all time occurred because capital dried up. If banks had continued to lend to each other in 2008-09, the financial crisis could have been mitigated somewhat.
The Federal Reserve managed to avoid making the same mistakes this time last year. By showering Wall Street with money, companies like Carnival (CCL, Financial) were able to raise billions. The amount of debt Carnival had going into the crisis didn't matter. What mattered was its ability to raise even more funds from creditors. In the first ten months of last year, U.S. corporations raised $2.2 trillion of debt - about $1.8 trillion of investment-grade corporate bonds and another $371 billion of "junk" rated debt. That's excluding equity fundraisings.
The availability of debt helped even highly-geared companies survive. Therefore, when looking for the answer to the question "how much debt should a company have?" one needs to consider both the company's balance sheet and the general credit environment.
Of course, zero debt is the best answer. However, other indicators like debt duration and if the interest rate on the debt is fixed or floating can give precious insights into the sustainability of the borrowing.
Disclosure: The author owns no share mentioned.
Read more here:
- How Much Time Should we Spend Analyzing a Business?
- Investors Lack Patience at Every Stage of the Process
- 3 Lessons From the Collapse of Long-Term Capital Management
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