In today’s blog post, I would like to talk more about debt. Many a times, debts are always cast with a negative light as we are used to the narratives told to us like how one can go bankrupt due to mounting debt. There are definitely some truth to that but debts can be good as well. Generally if debts are used to purchase income generating assets that can yield more than the interest rate of the debt then it is good debt. On the other hand, many people tend to get into debt spiral because their purchase are often liabilities than an asset. For instance, swiping your credit card for a new bag or a new gadget etc.
The general rule of thumb is that:
Total assets’ yield > Interest rate of debt
for it to be a good debt.
Likewise for a company, the understanding of debt is the same. For whatever reason that the company decides to take on debt, the things that the debt is use for should generate a yield that is more than the interest rate of the debt. I will show you 3 ways to tell if the company’s debt is good or bad in a company.
1) Look at the revenue and profit
For a company to take up debt, it’s foremost objective is to grow the business. If taking on the debt does not lead to higher revenue and profit growth, then there is reason to believe that the debt the company take on is not really good.
2) Is there cash flow into the business?
Another important way to tell if the company’s debt is good or not is based on whether the business can generate cash flow to pay off the debt. If the business can bring in monthly cash that are more than the debt payment then the debt is good. Likewise if the company is consistently registering negative cash flow it is likely that the company may take on more debt to pay off current debt which is not good.
3) Is there cash to pay off interests?
Having back up cash is important for emergency uses. In order for the company to be able to operate smoothly it should be able to pay off its interests with some of the back up cash it have. This ensures that the company don’t run into a situation whereby they are unable to meet debt obligation because there are some bad months in the business.
We shall take a look at two different company and their use of debt to try to understand good and bad debts.
Total Debt for Company A = USD $ 4,042,853,000
Company B total debt = USD $ 68,678,591
— Revenue and Profit —
Declining revenue and loss making company.
High revenue growth and profit making.
— Cash Flow —
Cash not coming into the company from their existing business.
Cash into company from existing business is positive.
— Sufficiency of cash to meet debt obligations —
Interest expense is about USD $ 200 million every year, but Company A have only USD$ 300 million left in 2016. Will they be able to tide through another year?
Company B’s yearly payment is about US$ 6 million which is easily covered by the amount of cash and cash equivalents they have.
hopefully the above case study is able to show you in real life the difference between good and bad debt in a company. For those who are curious, Company A is Noble Group and Company B is Geo Energy Resources. All the 3 ways describe above should be look in totality with a company’s business model to understand if the debt are sustainable. For instance, in a cyclical industry, company’s earnings can be very high in a bullish up cycle, this can mask out some of the red flags of their debts. Hence it’s good to use these 3 ways and compare it across a few years to understand if they have been able to manage their debts well.