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Why Debt Makes Buffett Nervous!

The Role of Debt in Evaluating an Investment Opportunity

Deep-Dive

Debt financing is kind of like the double-edged sword of the finance world.

On one side, it's a powerful tool that companies can use to boost growth and keep things running smoothly without giving up any ownership. But on the flip side, if it's not handled right, it can become a real drag on the company.

To really understand a company’s financial health, investors need to get a good grip on how debt works and how to evaluate it. In this article, we'll focus on the different ways of measuring a company's debt level, the different types of debt, and the role of the interest rate, along with a practical example using a comparison between Nike and Adidas.

So, let's dive in!

THE REAL COST OF BORROWING MONEY

When companies borrow money, they’re basically paying for the privilege of using someone else’s cash, it’s that simple. The main cost here is the interest on the borrowed funds.

But here’s a little insider tip: that interest is often tax-deductible, which can really cut down the total cost of debt.

This tax perk can make debt financing cheaper than selling equity, where dividends aren’t usually tax-deductible. So, when you’re digging into a company’s finances, don’t forget to factor in this tax break to get the full picture of how debt stacks up against other options.

MEASURING DEBT: MORE THAN JUST A NUMBER

One of the key metrics to check out is the Debt-to-Equity ratio (D/E ratio). This tells you how much of a company’s capital (funding) comes from debt versus equity. For example, if a company has $2 billion in debt and $10 billion in equity, the D/E ratio would be 0.2, meaning there’s $5 of equity for every $1 of debt.

At Raising InvestorIQ, we typically prefer companies with a D/E ratio < 0.8.

But while a lower D/E ratio generally suggests a company isn’t overly reliant on debt, it’s not a one-size-fits-all figure. As we often have said, different industries have different norms, so it’s wise to compare a company’s D/E ratio with others in the same sector!

Here is the general formula to keep in mind:

Creditors often see companies with lower D/E ratios as safer bets, which can make it easier for these companies to get future loans and snag better terms, but remember - what’s considered an ideal D/E ratio can vary widely by industry. 

For instance, utilities companies might operate with higher D/E ratios because their revenue is relatively stable, while tech companies might keep debt levels lower due to market volatility. It's all about gauging.

NAVIGATING ALL TYPES OF DEBT

Debt comes in all sorts of flavors, each with its own set of perks and drawbacks. Companies have a range of options to choose from, depending on their needs and financial strategies.

• Term Loans: these are the classic loans where a company borrows a lump sum and pays it back over time with fixed payments. Great for companies with steady cash flows.

• Lines of Credit: think of these like you would a credit card. Companies can borrow up to a certain limit as needed and only pay interest on what they use. This flexibility is perfect for managing short-term cash flow.

• Revolving Credit Facilities: these are similar to lines of credit but usually on a larger scale. Companies can draw and repay funds multiple times up to a set limit, ideal for ongoing operational needs.

• Equipment Financing: this is where the equipment itself often serves as collateral, which can reduce borrowing costs.

• Convertible Debt: gives lenders the option to convert the debt into equity later on, which can be a win-win if the company’s stock price rises.

DEBT FINANCING VS. INTEREST RATES: THE DELICATE BALANCE

The cost of debt is closely tied to interest rates, which are influenced by market conditions and the borrower’s creditworthiness. It’s easy to remember: low interest rates make debt financing more attractive because borrowing is cheaper. This is why companies often ramp up borrowing when rates are low.

But watch out: borrowing too much, even at low rates, can lead to being over-leveraged, which might increase the overall cost of capital and risk the company’s financial health.

When interest rates are high, companies might be more cautious about taking on new debt since higher rates mean higher borrowing costs. This can squeeze profit margins and reduce cash flow available for other investments.

Plus, there could be covenants—conditions set by lenders that companies must meet to avoid default, like maintaining certain financial ratios or limiting additional borrowing. These can restrict a company’s flexibility.

So beware: the interest rate is the key component of debt, at any level!

THE DEBT VS. EQUITY DEBATE

When it comes to corporate finance, choosing between debt and equity is a big decision. What are the differences and how should you assess it all?

Let’s break it all down with a concrete example relative to “the sneaker saga,” using a comparison of Nike and Adidas as an example.

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