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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.

The main difference is ownership: 

• Debt financing means borrowing money that needs to be repaid, usually with interest, but it doesn’t dilute ownership.

• Equity financing means selling a portion of the company to investors, which dilutes ownership but doesn’t require repayment.

So which is the wiser choice? It depends on some criteria.

Most companies use a mix of both to balance their financial needs and goals. The right mix depends on factors like cash flow, control preferences, and financing accessibility.

A startup might lean towards equity financing to avoid debt pressures, while a well-established company with steady cash flow might prefer debt financing to keep ownership intact.

Debt financing is often seen as more cost-effective, especially when interest rates are low. It allows companies to leverage a small amount of capital for bigger gains, thanks to tax benefits and the fact that once the debt is repaid, the obligation ends. On the flip side, managing debt can be tricky with regular interest payments that might strain cash flow and increase financial risk.

On the other hand, equity financing, while diluting ownership, doesn’t require repayment and doesn’t add to the debt load. This is handy for companies in volatile industries or with uncertain cash flows. However, giving up equity means sharing future profits and decision-making with new investors, which might not always align with long-term goals.

DEBT DYNAMICS: A SNEAKER SAGA

Let’s see how debt management plays out in real life with Nike and Adidas, and some of their debt indicators that you should look at when assessing the debt of a company.

Looking at Nike’s financials, their interest expense in the last 12 months is $269 million, which might sound big, but it’s pretty manageable given their earnings before interest and taxes (EBIT) of $6,754 million. This means Nike’s interest payments are well within their means, even if they hit some financial bumps. They’ve got this covered!

The cash flow is strong, too, with a free cash flow (FCF) of $5,901 million. Levered free cash flow is the cash left over after capital expenditures and interest repayment, and it’s a key indicator of financial health because it's literally the cash remaining in the company after all its sales, investments and all costs that have been paid.

Nike’s FCF far exceeds their interest obligations, showing they’ve got plenty of cash for debt payments and other investments. They have a “financial cushion.”

Their balance sheet reveals $7,934 million in long-term debt and $9,860 million in cash reserves. This strong cash position, combined with solid FCF, means Nike can handle its long-term debt without rocking the boat.

Looking at the financials of Adidas, Nike's competitor, we note that they appear to be in an effective position in terms of debt management, as their EBIT enables them to cover interest, but to a lesser extent than Nike.

Also, their cash reserves are not as high, relative to interest paid, and their cash flow has sometimes been negative. Overall, Nike seems to manage its cash better, but different management policies may apply to each company!

RATIOS THAT MATTER

While the D/E ratio is a good starting point, other ratios can give extra insights. Let’s take a look on these with the same example to picture it.

The current ratio measures a company’s ability to pay short-term obligations (current assets/current liabilities). A higher ratio means a better ability to meet these obligations.

In the case of Nike and Adidas, since Nike has a higher cash reserve relative to its debts than Adidas, the ratio has been consistently higher for several years.

Another one is the interest coverage ratio, used to check how easily a company can cover interest payments with its earnings (operating income/interest expense). A higher ratio means more cushion against default. In June, the Adidas ratio was 5.6 vs. 25.9 for Nike, showing Nike's greater ability to pay interest.

Finally, at Raising InvestorIQ we emphasize an analysis of a company’s long-term debt versus its earnings. The best test of a company’s financial power with respect to the burden of debt is its ability to service and pay off debt out of its earnings.

Companies with a durable competitive advantage typically have a long-term debt burdens of fewer than 5x current net earnings.

About the debt-to-equity ratio, still key for balancing debt and equity financing, here is those from Nike and Adidas; lower ratios are usually seen as less risky, but again context within the industry matters.

CONCLUSION

Debt financing can be a great way to drive growth and create value, but it comes with risks. By carefully analyzing financial statements and key debt metrics, investors can get a clearer picture of a company’s financial health.

Nike’s balanced approach to debt management is a great example of how to use debt wisely to support long-term success without compromising stability.

According to Warren Buffett: A good indication of a durable competitive advantage is a company’s ability to maintain a relatively little to no long-term debt and spins off a lot of cash.

As you dive into investment opportunities, remember that debt is just one piece of the puzzle. Consider a company’s overall financial strategy, market position, and industry to make informed decisions.

With these insights, you’ll be better equipped to understand the role of debt and make investment choices that fit your goals!

Stay tuned for more investment insights to help you navigate the financial world with confidence and clarity!

Key Insight

According to Warren Buffett: A good indication of a durable competitive advantage is a company’s ability to maintain a relatively little to no long-term debt and spins off a lot of cash.

High levels of long-term debt impede a company’s ability to survive a business recession or calamity.

Such events often decrease a business’s profitability (at least temporarily), leaving the company strapped for cash. This can potentially be to a company’s ruin if it is also carrying a large debt load.

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Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions.  I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP.

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