In spite of what Shakespeare might have led you to
believe, debt is a constant of life. And contrary to popular conception,
it's not always a bad thing.
Debt in the form of a mortgage allows you to purchase
a house before you've reached retirement age, and debt lets you
buy a car without throwing $20,000 down all at once. And being able
to buy stocks on margin -- which is simply another form of debt
-- was what allowed a lot of paper millionaires to become actual
Rather than cursing debt, it should be viewed as a
positive -- provided it's taken in moderation.
Take a look at corporate America's love affair with
leverage. The ability to borrow capital has paved the way for many
a mom-and-pop company to grow into a sector leader, yet it has also
driven many of the best intentioned corporations into the ground.
To ensure that most industry follows the middle road, banks and
accountants came up with the notion of the debt-to-equity ratio.
The debt-to-equity ratio is nothing more than a measure
of what a company owes vs. the amount of money it has invested in
it -- be it from its original owners or investors in the public
market -- including any retained earnings. (The denominator can
also be referred to as a company's net assets).
The formula's simple enough, but why should this
be important to shareholders? Simple: The more outstanding debt
a company has, the more its earnings must go to making the payments
on this debt load. This in turn will limit the amount of capital
that can go to growing the business, research and development,
or simply paying good old dividends
Also, the more debt a company carries, the more
the company is effectively owned by its lenders. When a company
begins to run into trouble, the friendly banker who encouraged
the business to borrow $100 million is quickly replaced by bank
envoys who more closely resemble representatives of the Gambino
family. No, bank reps don't break knuckles, but they do insist
that the company consider its creditors' needs above those of
everyone else, including shareholders. In fact, most large banks
have "workout" groups whose only purpose is to ensure that debtors
who look like they might have trouble making interest payments
find the money. To do this, banks use the threat of calling their
loans -- thereby causing a domino effect among other lenders and
sending the company into bankruptcy -- and thus often can facilitate
the sale of core assets or budget reductions that might hamper
the company's long-term growth, but will free up cash to pay interest.
Even though lenders will resort to such hardball
tactics, they prefer to dole out their money only to companies
that should be able to make their interest payments easily. To
try to ensure this, banks not only employ the debt-to-equity ratio,
but also consider the placement of the new loan in the debt priority
structure and the value of the company's physical holdings (which
can be liquidated in the event of bankruptcy). Debt has many levels,
from senior debt, which will be repaid first in the event of bankruptcy,
to subordinated debt, which will be repaid only after the senior
loans before it, if at all.
So how much debt is too much when you're looking
at a company's balance sheet? It's difficult to say, especially
since a number of tricks have been conceived to mask a company's
indebtedness -- including delaying executive bonuses until after
the quarter's close and repaying short-term debt, then re-borrowing
the same amount after the numbers have been fixed on the balance
While lenders are generally comfortable with a company
having a debt-to-equity ratio of as much as 50%, generally, you
should set your sites on companies with relatively little, or
no debt. Companies with debt less than 20 percent of its long-term
capital (that is, long-term debt and equity) should have the best
shot at financing long-term growth. Also, newer companies with
high debt loads should be analyzed closely, as building up leverage
early in a company's life could be a sign of a flawed business
plan or inefficient management.
Like gambling, drinking, rich foods and higher education,
debt can be useful and positive, so long as it's used in moderation.
-- Posted: Nov. 1, 2000