One of the themes that runs through all of my investment writing and investments is debt. The most successful investments do not have a large debt pile to maintain and as a result are not subject to the whims of creditors and dependent on capital markets. Cash is king and the more cash a company has, both on its balance sheet and generated from operations, the better.
The question is, is this the right viewpoint? Should I, and other investors, be avoiding businesses with elevated levels of debt?
Should you avoid debt
In the highly recommended book "The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success," the author profiles some of the best business managers to ever live, including the likes of John Malone, Kathrine Graham, Henry Singleton, Nick Chabraja and Tom Murphey.
These CEOs generated outstanding returns for shareholders during their tenures and had several common traits. They all hated investor relations, had strict capital allocation policies and were not averse to using debt. John Malone, whom many regard as being one of the best CEOs of all time, in particular, has built a reputation on the heavy use of debt and his companies are leveraged at four turns of EBITDA on average – significantly more than most other businesses would be able to stomach.
These CEOs all demonstrated that debt is not necessarily bad, and in the right hands it can be used to accelerate returns. Such an arrangement may not be suitable for most other companies.
A correct answer?
As with most things in investing, there’s no right or wrong answer as to how much debt is too much for a particular company. Most companies should not have an excessive amount of debt as these obligations can become crippling if the business environment turns. That being said, some businesses are better suited to debt than others.
John Malone’s Liberty Empire is one such group of businesses. Liberty has a stable income stream from cable subscriptions among other things, and this revenue predictability allows the company to borrow heavily, safe in the knowledge that interest and principal repayments will be covered by cash flow from operations.
On the other hand, businesses in the commodity industry are less suited to borrowing heavily. The cyclical nature of commodity prices means that companies cannot rely on earnings to remain stable for extended periods. Unfortunately, mining is a capital-intensive business, and it usually requires billions in debts or investment to begin production from a prospect in the first place.
Just between these two examples, there is a clear distinction between companies that require a significant amount of capital investment and those that have a relatively small asset base that can produce healthy cash flows. Arguably then, companies that have the highest returns on assets are the most suited to high debt levels. Unlike return on equity and return on invested capital, the return on assets is not so affected by high levels of debt and therefore will be a more reliable indicator of returns if the company decides to borrow heavily.
Another way to assess a business’ debt sustainability would be to evaluate debt in comparison to cash flow from operations. While the income statement can be manipulated to show the best version possible of a company, cash flows give a more reliable indicator of financial help, and after all, it’s cash on the balance sheet that will repay debt when it falls due, not noncash profits.
Overall, answering the question of how much debt is too much requires answers from several different channels. First of all the business needs to be assessed to see if it has cyclical cash flows and a low return on invested assets. If cash flows are robust and returns are steady, a company might be able to sustain debt better than most. That being said, even the most solid businesses can be sunk by taking on too much debt so really, there’s no exact answer.
