Debt test of Warren Buffett

3 Quick Tests for a Business with a long-term Durable Competitive Advantage:

1.   Earning Test

2.   Return (Profit) Test and

3.   Debt test.

3. Debt Test

"One of the things you will find---which is interesting and people don't think of it enough---with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my  experience: I've seen more people fail because of liquor and leverage---leverage being borrowed money."

                                      Warren Buffett

   

     INTEREST EXPENSE: WHAT WARREN DOESN'T WANT

Income Statement
($ in millions)
Revenue	$10,000
Cost of Goods Sold	3,000
->Gross Profit	7,000
Operating Expenses
Selling, General & Admin.	2,100
Research & Development	1,000
Depreciation	700
Operating Profit	3,200
->Interest Expense	$200

Interest Expense is the entry for the interest paid out, during the quarter or year, on the debt the company carries on its balance sheet as a liability. While it is possible for a company to be earning more in interest than it is paying out, as with a bank, the vast majority of manufacturing and retail  businesses pay out far more in interest than they earn.

This is called a financial cost, not an operating cost, and it is isolated out on its own, because it is not tied to any production or sales process. Instead, interest is reflective of the total debt that the company is carrying on its books. The more debt the company has, the more interest it has to pay.

Companies with high interest payments relative to operating income tend to be one of two types: 

• a company that is in a fiercely competitive industry, where large capital expenditures are required for it to stay competitive, or 
• a company with excellent business economics that acquired the debt when the company was bought in a leveraged buyout.

What Warren has figured out is that companies with a durable competitive advantage often carry little or no interest expense. Long-term competitive advantage holder Procter & Gamble has to pay a mere 8 % of its operating income out in interest costs; the Wrigley Co. has to pay an average 7%; contrast those two companies with Goodyear, which is in the highly competitive and capital-intensive tire business. Goodyear has to pay, on average, 49% of its operating income out in interest payments.

Even in highly competitive businesses like the airline industry, the amount of the operating income paid out in interest can be used to identify companies with a competitive advantage. The consistently profitable Southwest Airlines pays just 9% of operating income in interest payments, while its in-and-out-of-bankruptcy competitor United Airlines pays 61% of its operating income out in interest payments. Southwest's other troubled competitor, American Airlines, pays a whopping 92% of its operating income out in interest payments.

As a rule, Warren's favorite durable competitive advantage holders in the consumer products category all have interest payouts of less than 15% of operating income. But be aware that the percentage of interest payments to operating income varies greatly from industry to industry. As an example: Wells Fargo, a bank in which Warren owns a 14% stake, pays out approximately 30% of its operating income in interest payments, which seems high compared with Coke's, but actually makes the bank, out of America's top five, the one with the lowest and most attractive ratio. Wells Fargo is also the only one with a AAA rating from Standard & Poor's.

The ratio of interest payments to operating income can also be very informative as to the level of economic danger that a company is in. Take the investment banking business, which on average makes interest payments in the neighborhood of 70% of its operating income. A careful eye would have picked up the fact that in 2006 Bear Stearns reported that it was paying out 70% of its operating income in interest payments, but that by the quarter that ended in November 2007, its percentage of interest payments to operating income had jumped to 230%. This means that it had to dip into its shareholders' equity to make up the difference. In a highly leveraged operation like Bear Stearns, that spelled disaster. By March of 2008 the once mighty Bear Stearns, whose shares had traded as high as $170 the year before, was being forced to merge with JP Morgan Chase & Co. for a mere $10 a share.

The rule here is real simple: In any given industry the company with the lowest ratio of interest payments to operating income is usually the company most likely to have the competitive advantage. In Warren's world, investing in the company with a durable competitive advantage is the only way to ensure that we are going to get rich over the long-term.