DEBTS are often neglected in company analysis and valuations. Red flags.

Look out for companies that report consistent profits but also a substantial rise in gearing, which would indicate negative FCF.  

Receivables and/or inventories rise even faster than increasing sales

This is usually the case when companies report increasing sales but where receivables and/or inventories rise even faster.

If a company's receivables grow at a much faster rate than revenue, it will suffer net cash outflows, which have to be funded with increasing debt (or cash calls).  It can continue to report steady profits for many years - even as the company is being crushed by mounting debt and interest expenses.   Investors who are fixated on earnings would not realise the looming issue until it is too late.

Paying dividends in excess of cash flow from operations

Companies that pay dividends in excess of cash flow from operations may also warrant a red flag.  

This is the danger when management's interest are not always aligned with that of shareholders.  The fact is that management remuneration/incentives are usually based on profitability and share price gains, which encourages short-termism and risk-taking, including using leverage to boost earnings.  Anecdotal evidence shows that high dividends/share buybacks tend to lead to higher share prices.

Indeed, sometimes not all shareholder's interests align either.  Some are short term, preferring dividends/share buybacks while longer-term-minded investors would prefer companies to conserve cash for future opportunities and/or pay down their debts.

Borrowing to invest in productive assets

Companies necessarily reinvest for the future, funded with internally generated funds and/or borrowings and equity cash calls.  Borrowing to invest in productive assets that will generate future cash flows is perfectly fine - as long as the increased risks that come with it are understood and properly taken into consideration.

Company with less debts is less risky and better positioned

Company that pay off its debts would be better positioned to withstand any unexpected economic and financial shocks - thereby making it the safer investment.  It would be better able to capitalise on future opportunities - for example, mergers and acquisitions, relative to its competitors which large debts, thanks to its stronger balance sheet.

Conclusions

There will always exist a trade-off between risks and rewards.  It is important to analyse both aspects in tandem.  

There is nothing wrong if you choose to go for the higher returns, provided you also understand the risks and can stomach the potential losses.  

Some investors are risk takers, others are more risk-averse, but the smartest investors make informed decisions.

China's historical debt binge

September 2008, pre-Lehman Brothers bankruptcy

In September 2008, China's economy was slowing.   The Shanghai stock market had just crashed.  Property prices were weak.  The Chinese officials said China was entering the middle-income rank of nations, so it was time for it to slow down as previous Asian miracle economies, like Japan, South Korea and Taiwan, had.  They talked about cutting back on investment, downsizing large state companies and letting the market allocate credit, which at this point was not growing faster than the economy.  Between 2003 and 2008, credit had held steady at about 10% of GDP.

October 2008, post Lehman Brothers bankruptcy

Lehman Brothers filed for bankruptcy in the US and global markets went into a tail-spin.  Demand collapsed in the US and Europe, crushing export growth in China, where leaders panicked.

By October 2008, the Chinese government had reversed course, redoubling its commitment to the old investment -led growth model, this time by fueling the engine with debt.   From 2008 through 2018, total debts would increase by $80 trillion worldwide, as countries fought off the effects of the financial crisis, but of that total, $35 trillion, or nearly half, was racked up by China alone.

August 2009

By August 2009, the Chinese government had launched an aggressive spending and lending program that kept China's GDP growth above 8%, while the US and Europe were in recession.  That steadily high GDP growth had convinced many Chinese that their government could produce any growth rate it wanted.

Bank regulators were the only officials who expressed alarm and their main concern was increasingly reckless lending in the private sector.  "Shadow banks" had started to appear, selling credit products with yields that were too high to be true.  

2013

By 2013, shadow banks accounted for half of the trillions of dollars in new yearly credit flows in China.  When Beijing began to limit borrowing by local governments, local authorities set up shell companies to borrow from shadow banks.  Soon these "local government funding vehicles" became the biggest debtors in the shadow banking system.

As the flow of debt accelerated, more lending went to wasteful projects.  By some estimates, 10% of the firms on the mainland stock exchange were "zombie companies." kept alive by government loans.  The state doled out loans to incompetent and failing borrowers.

• Lending started to flow into real estate

Much of the lending started to flow into real estate, the worst target for investment binges.  Easy loans spurred the sale of about 800 million square feet of real estate in 2010, more than in all other market so the world combined.  In big cities, prices were rising at 20% to 30% a year.

Caught up in the excitement, banks stopped looking at whether borrowers had income and started lending on collateral - often property.  This "collateralized lending" works only as long as borrowers short on income can keep making loan payments by borrowing against the rising price of their property.  By 2013, a third of the new loans in China were gong to pay off old loans.  In October 2013, Bank of China chairman warned that shadow banking resembled a "Ponzi scheme," with more and more loans based on "empty real estate."

• At the March 2013 party congress, Li Keqiang came in as prime minister.  

He was one of the Chinese leaders who appeared to accept the reality that a maturing economy needed to slow down, which would allow him to restrain the credit boom.  Yet every time the economy showed signs of slowing, the government would reopen the credit spigot to revive it.

• Dubious creditors grew

The cast of dubious creditors grew increasingly flaky, including coal and steel companies with no experience in finance, guaranteeing billions of dollars in IOUs issued by their clients and partners.  

2014: Chinese urged to buy stocks

By 2014, lending entrepreneurs were shifting their sights from property to new markets - including the stock market.

Even the state-controlled media jumped in the game, urging ordinary Chinese to buy stocks for patriotic reasons.  Their hope was to create a steady bull market and provide debt-laden state companies with a new source of funding.  Instead they got one of the biggest stock bubbles in history.

There are 4 basic signs of a stock bubble:  

• high levels of borrowing for stock purchases; 
• prices rising at a pace that can't be justified by the underlying rate of economic growth; 
• overtrading by retail investors and 
• exorbitant valuation.  

June 2015, Shanghai market started to crash

By April 2015, when the state-run People's Daily crowed that the good times were "just beginning,"  The Shanghai market had reached the extreme end of all four bubble metrics, which is rare.

The amount that Chinese investors borrowed to buy stock had set a world record, equal to 9% of the total value of tradable stocks.  Stock prices were up 70% in just 6 months, despite slowing growth in the economy.  On some days, more stock was changing hands in China than in all other stock markets combined.  In June 2015, the market started to crash and it continued to crash despite government orders to investors not to sell.

[Comments:

This credit binge had some characteristics unique to China's state-run system, including the borrowing by local government fronts and the Communist propaganda cheering on a capitalist bubble.  But its fundamental dynamics were typical of debt mania.  It began with private players, who assume the government would not let them fail, and devolved into a game of whack-a-mole.  As the government fitfully tried to contain the mania, more and more dubious lenders and borrowers got in the game, blowing bubbles in stocks and real estate.  The quality of credit deteriorated sharply, into collateralized loans and IOUs.  These are all important mania warning signals.

The most important sign was, as ever, private credit growing much faster than the economy.   After holding steady before 2008, the debt burden exploded over the next 5 years, increasing by 74 % points as a share of GDP.  This was the largest credit boom ever recorded int he emerging world (though Ireland and Spain have outdone it in the developed world).]

By mid 2019

By mid-2019 China had, in fact, seen economic growth slow by nearly half, from double digits to 6%, right in line with previous extreme binges.  To date then, no country has escaped this rule:  a five-year increase in the ratio of private credit to GDP that is more than 40% points has always led to a sharp slowdown in economic growth.

[Comments:

China did however, dodge the less consistent threat of a financial crisis, aided by some unexpected strengths.  One was the dazzling boom in its tech sector, without which the economy would have slowed much more dramatically.  Another was the fact that Chinese borrowers were in debt mainly to Chinese lenders and in many cases the state owned bother parties to the loan.  In short, /China was well positioned to forgive or roll over its own debts.  And with strong export income, vast foreign exchange reserves, strong domestic savings and still ample bank deposits, it has managed to avert the financial crisis that often accompanies large, debt driven economic slowdowns.]

How Paying Off Debt Pays Off

Before 2000

Before 2000, many emerging countries had never seen a period of real financial stability or a healthy credit boom.  

• Inflation was high and volatile, and when prices for big-ticket items are unpredictable, banks won't dare make loans that extend for more than a few months.
• In emerging countries, five-year car loan and the 30 year mortgage, had been unimaginable luxuries.  Yet, these are the many cornerstones of American consumer culture and middle-class existence.

After 2000

The new generation of emerging world leaders began controlling deficits and lowering inflation.  This newly stable environment quickly led to a revolution in lending.  

• Credit cards and corporate bonds were introduced for the first time.
• Mortgages, which barely existed in 2000, became a multibillion-dollar industry, rising from 0% of GDP to 7% in Brazil and Turkey, 4% in Russia and 3% in Indonesia by 2013.

For countries where people cannot buy a car or a house unless they amass enough cash, the introduction of these simple credit products is an important step into the modern world.

Periods of healthy credit growth

Periods of healthy credit growth bear no psychological resemblance to the extreme exuberance of manias or the extreme caution of debt-phobia.  

In place of shady lenders and unqualified borrowers, responsible lenders are widening the choice of solid loan options, creating a more balanced economy.

Global financial crisis in 2008

When the global financial crisis hit in 2008, countries like the US were vulnerable because they had been running up debt too fast.  

In Southeast Asia, however, the opposite story was unfolding.

Indonesia, Thailand, Malaysia and the Philippines had manageable debt burdens and strong banks ready to lend, with total loans less than 80% of deposits.  

Over the next 5 years the health of the credit system would prove crucial:  

• nations such as Spain and Greece, which had seen the sharpest increase in debt before 2008,  would post the slowest growth after the crisis; 
• nations such as the Philippines and Thailand, which had seen the smallest in debt during the boom, would fare the best.

Debt Mania and Debt Phobia

Debts owed by nations

Every new crisis seemed to hatch a new way of thinking about debt, depending on who is lending, who is borrowing, for how long, and many other factors.

• Mexico's "tequila crisis" of the mid-1990s started with short-term bonds.  This led to focus on the dangers of short-term debt.
• The Asian financial crisis started with debt to foreigners, and foreign loans became the new obsession.

The best predictor of these meltdowns:  five straight years of rapid growth in private-sector debt.  

A decade after the global financial crisis, the Bank of International Settlements, the IMF and other international authorities concurred the most consistent precursor of major credit crises going back to the "tulip mania" in 17th century Holland was that private-sector debt - borrowing by corporations and individuals - had been growing faster than the economy for a significant length of time.

The authorities also reached another surprising conclusion:  the clearest signal of coming trouble is the pace of increase in debt, not the size of the debt.  

• Size matters, but pace matters more.  
• Government debt play a role but usually rises later, after trouble starts in the private sector.  
• A sharp increase in private debt is the leading indicator.

The key issue is whether debt is growing faster or slower than the economy.   

• A country in which private credit has been growing much faster than the economy for 5 years should be placed on watch for a sharp slowdown in the economy and possibly for a financial crisis as well.

Thailand in 1997

From the prime minister to farmers gets swept up in the mania for cheap loans. 

A housewife borrows to invest in "four million of anything."  

By 1997, private debt amounted to 165% of GDP in Thailand, but debts of that size would not necessarily have signaled a crisis if the debt had not been growing at an unsustainable pace.

• Over the previous 5 years, private debt had been growing at an annual pace more than twice as fast as the roaring Thai economy and had rise by 67% points as a share of GDP.  

To anticipate coming trouble, the number to watch:  the five-year increase in the ratio of private credit to GDP.

Successful nations avoid debt manias

Successful nations avoid debt manias and are often best positioned for sustained growth after a period of retrenchment.  

• The upside to the rule is that if private credit has been growing much slower than the economy for 5 years, the economy could be headed for recovery, because banks will have rebuilt deposits and will feel comfortable lending again.  
• Borrowers, having reduced their debt burden, will feel comfortable borrowing again.  

That is the normal cycle anyway. 

Debt phobia can be almost as destructive

 After particularly severe credit crises, lenders and borrowers may be paralyzed for years by debt phobia, which can be almost as destructive as debt mania.

Indebtedness

We should steer clear of businesses that are highly indebted, since they can negate our estimates of future earnings.

Debt improves the return on capital, but the increased volatility from interest payments can become impossible to bear.

The limit for acceptable levels of debt depends on the stability of the business; the more stable - with an easy to predict outlook (toll road, electricity networks, etc.) - the more manageable the debt.

The undeniable advantage of working without debt or other liabilities is that we can withstand any situation with the necessary peace of mind.

Debt requires us to be more precise with our predictions that is desirable, especially given the near impossibility of correctly forecasting what will happen and the inevitability of devastating surprises.

Although indebtedness doesn't directly impact on the valuation, it is important to be very aware of a company's debt levels, analysing its capacity to pay back debt: size, term, restrictions, etc.

Billionaire Ray Dalio: Don't take on debt until you've asked yourself this question

Thu, 25 Oct 2018

Many young people are deep in debt: Millennials between the ages of 25 and 34 have an average of $42,000 of debt per person and members of Gen Z (ages 16 to 20) already have an average debt of $4,343. And as interest rates rise, that debt is often becoming more expensive to pay off.

Billionaire investor Ray Dalio, the founder of the world's largest hedge fund, Bridgewater Associates, advises young people to do a bit of analysis before they agree to take out a loan.

"Be very careful about debt," Dalio tells CNBC Make It. "Some is good and some is bad."

When it comes to borrowing money you'll have to pay back at a higher cost — anything from credit card debt to student loans to home mortgages and auto loans — Dalio suggests asking yourself one question: Will the debt help you save or earn more money in the future?

"Debt that produces more cash flow than it costs is good," Dalio says. For example, taking a loan to complete an advanced degree that will raise your salary above the cost of the loan's monthly payments and interest is a good form of debt, according to Dalio.

Another type of good debt is the kind that forces you to save money over time. For example, monthly payments on a home mortgage are a type of forced savings, he says, because you are socking away money into an asset you can later sell.

Since Americans often struggle to save (the personal savings rate has hovered around 6.6 percent in the U.S. since June) forced savings can be an important mechanism for Americans to store wealth without being tempted to spend it.

"Debt that creates forced savings, which is greater than you would save if you didn't have it, like buying a house, will produce good debt," Dalio explains.

Unlike taking on debt to earn more or to save more, getting a loan to buy something that won't help you in the future is a bad idea.

"Debt for consumption, or for anything that doesn't produce more income than it costs, is bad debt," Dalio says.

Racking up credit card debt by shopping for clothes or dining out and not paying off the balance at the end of the month is an example of bad debt. The average interest rate on credit cards is close to 17 percent, and consumers spent over $100 billion on credit card interest payments and fees in the last year, according to data from Magnify Money.

As a rule, Dalio prefers to avoid taking on debt whenever he can.

"I'm personally very debt and risk averse — probably too much so," he says. "That's probably because my dad lived through the Great Depression and war and he impressed upon me the freedom from worry one gets from having savings and no debt."

Dalio is worth an estimated $18 billion, according to Forbes, and founded Bridgewater Associates in his two-bedroom apartment in New York in 1975. From its founding through 2017, Bridgewater returned the biggest cumulative net profit for a hedge fund ever, according to data from LCH Investments.

"I never had significant personal debt, and I built Bridgewater without borrowing a dime or raising a dime from outside equity, and I made sure it has significant savings," Dalio says. "Besides having peace of mind, it gave me the power of knowing that I could never be knocked out of the game."



https://www.cnbc.com/2018/10/23/ray-dalio-ask-yourself-this-question-before-taking-on-debt.html

Determining the Payback Period. When are borrowings excessive?

In the balance sheet, the total liabilities exceed the total equity overwhelmingly.  What does this mean?

There are 3 possible types of scenarios when this happens:

1.  The company has excessive long term borrowings.
2.  The company has excellent business that uses very little equity and its business is funded mainly by its creditors.
3.  The low equity is due to accumulated deficit, the result from continuing losses in operations.




Let us look at scenario No. 1:  The company has excessive long term borrowings.

Companies normally borrow money from financial institutions to fund their expansion.

• This is even more prevalent in an environment where the interest rates are low.
• Some companies will also refinance their debt by taking advantage of the low interest rate so that they can enjoy some savings in the interest payable.
• Yet others will refinance their debt with a higher interest rate to extend the maturity date of the debt.

All the above make business sense, when the return on capital is higher than the cost of capital.  

But, if the business continues to suffer despite the injection of additional funds through borrowings, then the company could be in dire straits.

When are borrowings excessive?  How do you determine this?

The key is in the payback period.

Look at the amount of long-term borrowings (normally found under the heading of Non-Current Liabilities) and then the Net Profit (found in the Income Statement).

Assuming that the company can utilise ALL its Net Profits in its present financial year to pay off its long term borrowings AND the SAME Net Profit recurs every year, you have this formula:

Payback Period in years = Long Term Borrowings /Net Profit.

The resulting answer is the payback period for the long-term borrowings.

A prudent KPI for the payback period is not more than 5 years.

Yes, you can argue that the company can achieve tremendous profit growth in the next few years.  If that happens, the number of years required to pay off its debts can be reduced dramatically.  

By the same argument, what if the economy suffers and a loss is incurred?

Total Liabilities and the Debt to Shareholders' Equity ratio

TOTAL LIABILITIES AND THE DEBT TO SHAREHOLDERS' EQUITY RATIO

Balance Sheet/             Debt to Shareholders' Equity Ratio
($ in millions)
Total Current Liabilities	$13,225
Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
> Total Liabilities	$21,525

Total liabilities is the sum of all the liabilities of the company. It is an important number that can be used to give us the debt to shareholders' equity ratio, which, with slight modification, can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholders' equity ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).       

-  The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities. 

-  The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.

The equation is: Debt to Shareholders' Equity Ratio = Total Liabilities / Shareholders' Equity.

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don't need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don't need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business---one without a durable competitive advantage.

Moody's, a Warren favorite, is an excellent example of this phenomenon. It has such great economics working in its favor that it doesn't need to maintain any shareholders' equity. It actually spent all of its shareholders' equity on buying back its shares. It literally has negative shareholders' equity. This means that its debt to shareholders' equity ratio looks more like that of GM---a company without a durable competitive advantage and a negative net worth---than, say, that of Coca-Cola, a company with a durable competitive advantage.

However, if we add back into Moody's shareholders' equity the value of all the treasury stock that Moody has acquired through stock buybacks, then Moody's debt to equity ratio drops down to .63, in line with Coke's treasury share-adjusted ratio of .51. GM still has a negative net worth, even with the addition of the value of its treasury shares, which are nonexistent because GM doesn't have the money to buy back its shares.

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders' equity ratio. Durable competitive advantage holder Procter & Gamble has an adjusted ratio of .71; Wrigley, meanwhile, has a ratio of .68---which means that for every dollar of shareholders' equity Wrigley has, it also has 68 cents in debt. Contrast P&G and Wrigley with Goodyear Tire, which has an adjusted ratio of 4.35, or Ford, which has an adjusted ratio of 38.0. This means that for every dollar of shareholders' equity that Ford has, it also has $38 in debt---which equates to $7.2 billion in shareholders' equity and $275 billion in debt.

With financial institutions like banks, the ratios, on average, tend to be much higher than those of their manufacturing cousins. Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for. This leads to an enormous amount of liabilities, which are offset by a tremendous amount of assets. On average, the big American money center banks have $10 in liabilities for every dollar of shareholders' equity they keep on their books. This is what Warren means when he says that banks are highly leveraged operations. There are exceptions though and one of them is M&T Bank, a longtime Warren favorite. M&T has a ratio of 7.7, which is reflective of its management's more conservative lending practices.

The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders' equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.

And finding what one is looking for is always a good thing, especially if one is looking to get rich.

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.

How to calculate the Free Cash Flow to Firm and Free Cash Flow to Shareholders

There are two definitions of free cash flow, both of which are useful for investors:

1.  Free cash flow to the firm (FCFF)
2.  Free cash flow for shareholders (FCF).

Free cash flow for shareholders is also referred to as free cash flow for equity.

These can be calculated very easily from a company's cash flow statement.


FCFF

To calculate FCFF, take a company's cash flows from operating activities, add dividends received from joint ventures and subtract tax paid to get the net cash flow from operations.  The subtract capex.

Net cash from operations
less Capital expenditure
add Dividends from joint ventures
= FCFF



FCF

To calculate the FCF, take the FCFF number and subtract net interest (interest received less interest paid), any preference share dividends, and dividends to minority shareholders.


FCFF
less dividends paid to minorities
less interest paid
add interest received
=FCF




When FCFF is not much different from FCF

A company with very little debt and thus, a tiny interest payment, virtually all of the free cash flow produced by the business (FCFF) becomes free cash for the shareholders (FCF).

In such a company, there is not much difference between FCFF and FCF.

This is a positive sign for investors and investors should look for this sort of situation in companies they are analysing.


When FCFF is consistently different from FCF

A company with a lot of borrowings has high interest bills to pay.

In this company, the FCFF and FCF can be consistently different for many years.

This is because the interest payments eat up a big chunk of the company's FCFF, leaving less FCF for shareholders.




Avoid companies with lots of debt

In general, it is a good idea to avoid companies with lots of debt.

• Too much of their free cash flow to the firm can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their free cash flows to repay debt and lower their future interest bills.

• This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Additional notes

Free cash flow to the firm (FCFF)

The amount of cash left over to pay lenders and shareholders.

Operating cash flow less tax and capex.


Free cash flow (FCF)

The amount of cash left over after a company has paid all its non-discretionary costs.

It is the amount of cash that the company is free to pay to shareholders in a year.

Operating cash flow less tax and capex, interest paid and preference dividends.

Do you always avoid all companies with large amounts of debt?

In an ideal world, you will select to invest in companies that produce consistently high returns and have low levels of debt.

This is the essence of quality and safe investing.

Do you always avoid all companies with large amounts of debt?

Not necessarily.



When larger debts are not a problem

There are some companies which can cope with higher levels of debt and still potentially make good investments.

These are companies with very stable and predictable profits and cash flows.

They have consistently high debt to total asset ratio and quite low levels of interest cover, and yet, they have many of the hallmarks of a quality company.

They have

• grown their sales, profits (EBIT) and free cash flows, 
• whilst maintaining high profit margins (EBIT margins) and 
• very good levels of ROCE.

The general point is:  if a company shows it can continue to increase turnover and EBIT - sales and profit - year after year, whilst holding high levels of debt, this can still be regarded as a quality company and potentially a good investment.

Measuring a company's debt

There are lots of ratios which can be used to explain a company's debt position.

For most investors the following four will tell what they need to know:

1. Debt to free cash flow.
2. Debt to net operating cash flow.
3. Debt to assets.
4. Interest cover.

These ratios only deal with debt shown on a company's balance sheet.

Investors must also be aware and be able to deal with hidden, or off-balance sheet, debts too.

1.  Debt to free cash flow

Debt to free cash flow tells you how many years it would take to repay all a company's debt with the current rate of free cash flow it is producing.

The lower the number, the better, as a lower number means that a company can repay its debt quickly.

You should rarely look at a company with a debt to free cash flow ratio that has been consistently more than 10.

Debt to free cash flow is calculated as follows:  

debt to free cash flow = total borrowings / free cash flow

This ratio can give a high number for two reasons:

• high debt or
• low free cash flow.

It will give a negative number if a company has negative free cash flow.

Like all ratios, it is best looked at over a number of years to see if it is normal for a company to have a high value or it it is a recent trend.

Companies with low debt to free cash flow have enough free cash flow to pay off all their borrowings in a matter of months.

Property, pubs and utility companies normally have high levels of debt as they are deemed to have sufficiently stable cash flows to support it.

Example:  

Company X would take 200 years to repay its debts based on its current free cash flows.

Debt to free cash flow = 200.

This is not normal given its recent history.

This would suggest that you need to investigate what is going on.

• Has debt surged?
• Has free cash flow plummeted?
• Does the management have a plan to reduced debt and increase free cash flow?

2.  Debt to net operating cash flow

Net operating cash flow is the amount of cash a company has from trading after it has paid its taxes.

By comparing this number with the total amount of debt, you can see how long it would take the company to pay back the debt if it stopped investing in its assets.

The lower the number, the better.

It is calculated as follows:

debt to net operating cash flow = total borrowings / net operating cash flow

This is the worst-case scenario test.

This ratio assumes the company spends nothing at all on maintaining its assets for a period of time.

This only happen for a couple of years for most companies before their assets become worn out and lose their ability to make money.

Therefore, with most companies, you want to see a debt to net operating cash flow ratio of less than 3.

Value for this ratio of over 5, indicates companies with significant amounts of debt relative to their cash flows.

Companies with poor profits and cash flows have high debt to net operating cash flow and have increased financial risk.

3.  Debt to assets

Debt to assets tells what percentage of a company's assets is taken up by debt.

The higher the percentage, the more risky a company generally is.

It is calculated as follows:

debt to assets = total borrowings / total assets

Generally speaking, avoid companies where the debt to total assets ratio is more than 50%.

This is one of the reasons why shares of banks can be extremely risky, as debt to assets ratios are over 90% in 2016.

Company with a very low percentage of debt to its total assets is a good sign.  

4.  Interest cover

Interest cover is not a measure of debt, but a measure of how many times a company's annual trading profits (EBIT) can pay the interest on its debt.  

The higher the number, the safer the company is.

Interest cover is calculated as follows:

interest cover = EBIT / interest payable

Look for a figure of at least five times, however, prefer to invest in companies where the ratio is 10 or more.

Danger zone is when the interest cover falls to 3 or less.

Excluding utility companies and property companies which have high levels of debt - and therefore low interest cover - a figure of 5 means that profits can fall by at least 40% before the ratio starts getting into the danger zone of interest cover of 3 or less.

Summary:

For most investors the following four will tell what they need to know:

1.  Debt to free cash flow.

Avoid if Ratio > 10

Good if Ratio < 10

Lower the better

2.  Debt to net operating cash flow.

Avoid if Ratio > 5

Good if Ratio < 3

Lower the better

3.  Debt to assets.

Avoid if Ratio > 50%

Good if Ratio < 50%

Lower the better

4.  Interest cover.

Avoid if <3:1 div="">

Good if > 5:1

Higher the better

Using debt ratios to analyse companies

The debt measure ratios for five companies.

Name   Debt to OPCF   Debt/FCF   Interest Cover   Debt/Total Asset
A          7.8                     22.9                 1.8                 162.0%
B           0.2                      0.2             213.9                     6.7%
C           6.5                    47.9                 2.1                   43.3%
D           2.5                      4.1                 6.8                   44.3%
E           6.4                     39.1                 2.5                   58.1%


Company A
This company's debt would take nearly 23 years to pay back.  Debt/FCF = 22.9
Its profits cover its interest payments less than twice.  Interest cover = 1.8x.
This kind of situation represents a risk of going bankrupt if profits were to deteriorate.
This would be enough to put investors off buying its shares.

Company B
This company operates a chain of fast food pizza chain.
It has very low levels of debt on its balance sheet.  Debt/Total Asset = 6.7%.
It could repay all its borrowings in less than three months based on its current free cash flow - Debt/FCF = 0.2.
It has no problems paying the interest on it.  Interest cover is 213.9x.
This is a kind of company investors might want to own shares in.

Company C
This company is in the pub business.
Pub companies are frequently financed with high levels of debt.
These companies can also tend to be quite poor at producing lots of free cash flow, as they have to keep spending money to keep their pubs in good conditions. (Heavy capital expenditure).
This makes them quite risky investments for shareholders when times get tough and profits fall.
These companies are often forced to sell their assets - pubs - to repay debts.

Company E
This is a water company (utility company).
Water companies are financed with lots of debt.  Debt/Total Asset = 58.1%.
This is not usually a problem given that they have very stable and predictable profits and cash flows.
Water is not the kind of product that tends to see demand change if the economy changes.
However, if investors are building a portfolio of quality companies with high free cash flows and ROCE, then it is unlikely that they will own shares of water companies.
This is because the returns they can earn are capped by industry regulators, which means they have very low ROCE.

Company D 
This is a hotel chain company.
Its business is conservatively financed and meets investors' target debt criteria.

Prudent financing

Having a load of debt is not itself a bad thing.

Having a loa of debt that cannot be easily financed by the cash flow of the business is a recipe for disaster.

When analysing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

Change in Debt by Borrower Age (auto loans, student loans, credit card and mortgage debts)

A couple of things stand out. First, overall growth in debt remains considerably more muted in 2013 than it was in 2006, with the exception of auto loans, where 2013 data continued to reflect the strong growth we have been seeing since mid-2011, and student loans. (In the case of student loans, the percentage growth has moderated since 2006, but since the outstanding balance has doubled, the lower percentage growth is associated with comparable dollar increases.) Mortgage and home equity line of credit (HELOC) balances, in particular, grew much more slowly in 2013 than in 2006. Second, for all loan types and in both years, balance increases were mainly driven by younger age groups. Again, though, student loans are an exception: even older student loan borrowers continue to increase their borrowing.

The next two charts break down the same data, this time by Equifax risk score (or credit score) groups.

On the credit score breakdown we see stark differences in patterns for mortgages and HELOCs between the 2013 and 2006 cohorts. Notably, in 2013, balances fell for the lowest credit score borrowers—the result of charge-offs from previous foreclosures—while all groups, even those with subprime credit scores, increased their mortgage balances in 2006. Now, the modest mortgage balance increases we see are mainly coming from high credit score borrowers.

A similar picture emerges for credit card balances. Note, though, that credit card balances for subprime borrowers were falling in 2006, again mostly due to charge-offs, making the increased mortgage balance for that group in 2006 seem all the more remarkable.

There’s been a tremendous amount of attention to the growth of student loans in recent years, and these charts indicate some of the reason why. First, student loans grew the most of any debt product in both periods (in percentage terms). Second, the growth in educational debt, like that of auto loans, is concentrated among the lower and middle credit score groups.

But auto and student loans have been growing for some time, while overall debt continued to fall. In 2013, the increased credit card and mortgage debt among the young and the riskless led to a turnaround in the trajectory of overall debt.

For a more detailed look at net borrowing by age and credit score in 2006 and 2013, please take a look at our interactive graphic.

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

http://economistsview.typepad.com/

The more debt you take on, the higher the risk

The higher the net gearing figure, the riskier the investment becomes.  This is basically because debt has to be paid back no matter what happens to your sales.  Costs are generally more fixed, whilst income for most businesses is variable and can fluctuate wildly.  

For example, the manufacturer of high-end electronic consumer goods that is very heavily geared is likely to face a potentially serious problem in the event of a sudden economic downturn.  The debt, however, as a fixed cost, would remain.  This is how large numbers of businesses go under.

A business in the same sector with little or no debt and a healthy bank balance is far more likely to weather the economic storm.  Recessions are nothing new, they have happened before and will do so again.

Does any business really have an excuse for not being prepared for them?  



[So the world will almost certainly face further financial shocks and economic events that will surprise us, and whilst we can't say when it will happen or how exactly it will play out next time around, sometimes it really can feel like a little bit of history repeating as the stock market will continue to behave in both a rational and irrational manner without warning. 

That is why it is so important to think about the business, and not the share price or even what the market is really doing at all.]

What are the 3 financial risks in an investment?

What causes financial risks in an investment?

1.  Excessive debt
"Only when the tide goes out do you discover who's been swimming naked."  - Warren Buffett. 
Companies incur debts because they want to speed up time.  They can own assets now instead of waiting for them later.  Why is speeding up time a bad thing?
These are often the companies and people with a lot of debts when the market collapses.

2.  Overpaying for an investment.
Price is what you pay.  Value is what you get.  - Warren Buffett
The asset quality has not changed.  The market conditions has not changed.  The poor investment was based on the initial price paid, not the quality of the asset.  The investor overpaid to own the asset or stock.

3.  Not knowing what you're doing.
"Risk comes from not knowing what you're doing." - Warren Buffett.
Why do people value the ownership of a house but not value the ownership of a company?
People understand how to value a house.  Many people do not understand how to value a company or stock.  They definitely do not understand the value of the company when they are broken down into many shares.  So, that is the true risk here and if you are the type of person who buys company shares and never look at what they are worth and buying on the basis that "well I like this company", you are probably setting up yourself up for buying too high above the true value of the share.

Leverage

Using OPM (other people's money) to make money is smart business as long as the company doesn't go over its head in debt.

From the perspective of a shareholder, the more revenue-producing assets a company can put into play without requiring more money from the shareholders, the better.

The downside, of course, is the vulnerability issue and what creditors might do if the income dries up enough to make servicing the debt difficult or impossible.

Common ratios to evaluate leverage are:

1.  Debt to Assets (Total Debt / Total Assets)
2.  Assets to Equity (Total Assets / Shareholder Equity)
3.  Debt to Equity (Total Debt / Shareholder Equity)
4.  Debt to Capital (Long-term Debt / Total Capitalization)


Don't base an investment solely on any of the ratios above.  Their most useful purpose could be to call your attention to possible upcoming changes in your quality criteria and might lead you to be more vigilant about them as you manage your portfolio.



Debt Service

For those companies with high leverage, you should also look at their ability to service their debts.  For this, look at these ratios:

1.  Interest Coverage (EBIT / Interest)
2.  Interest and Principal Coverage  [EBIT / (Interest + Adjusted Principal Repayments)]

Definition of 'Leverage Ratio'

Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses.

Investopedia explains 'Leverage Ratio'

The most well known financial leverage ratio is the debt-to-equity ratio. For example, if a company has $10M in debt and $20M in equity, it has a debt-to-equity ratio of 0.5 ($10M/$20M).

Read more: http://www.investopedia.com/terms/l/leverageratio.asp#ixzz2ALwlASAr

Corporate Finance - Factors that Influence a Company's Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are:

1.Business risk
2.Company's tax exposure
3.Financial flexibility
4. Management style
5.Growth rate
6.Market Conditions

1.Business RiskExcluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2.Company's Tax ExposureDebt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.

3.Financial FlexibilityThis is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.

The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.

4.Management Style Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).

5.Growth RateFirms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.

More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.

6.Market ConditionsMarket conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/capital-structure-decision-factors.asp#ixzz1yevRPv00