Risk of Loss Caused by a Company's Indebtedness

Companies that choose to finance a large proportion of their assets with borrowed money face an increased risk of being unable to meet their financial obligations.  The greater a company's reliance on debt, the more likely that the company will be unable to service the required interest and principal payments that come from debt.  A large amount of debt also tends to produce large variations in a firm's net income, which places the stockholder in a riskier position because it is more difficult to forecast earnings and dividends.

A company that relies mostly on earnings and owner contributions to pay for new assets has few fixed financial expenses to meet and is likely to be able to continue to meet its financial obligations when it encounters difficult economic conditions.

• A business with a substantial amount of debt is likely to encounter difficulties when revenues decrease.  
• Difficulties may also arise when revenues increase more slowly than the firm's management expected at the time the funds were borrowed.

If being in debt is so risky, why do most companies so readily employ this method of financing?  

• The answer is that debt allows a company to acquire more assets and grow more rapidly than would reliance solely on earnings and stockholders' contributions.  
• A company that conscientiously avoids borrowing money may have to delay its expansion plans because of the limited funds available to pay for new assets.  
• Delayed expansion may allow the firm's competitors to gain an advantage by reaching new markets or developing new products first.  
• A delay in expansion plans may also keep a firm from being among the first in its industry to reach a cost-efficient size.

Borrowing money rather than issuing additional shares of stock permits a business to expand without having to share control and profits with additional owners.  The firm also saves on future dividend payments.

• A firm that borrows $500,000 avoids having to sell thousands of additional shares of common stock on which dividends are likely to be paid in the future even if no dividends are currently being paid.  
• In addition, while dividend payments to stockholders must be paid from after-tax income, interest paid on debt is permitted as a deduction in calculating taxable income.  
• In other words, the interest expense from borrowing results in a tax benefit for the borrower.

Another potential advantage of borrowing is that debt financing will allow a company that experiences favourable business conditions to earn a higher return on the stockholders' investment.

• A decision to seek a long-term loan at a fixed rate of interest can prove to be a very wise decision if a company's productivity and revenues grow.  The fixed interest expense means that a substantial proportion of revenue growth is likely to flow down as profits for the stockholders.

Looking Into A Company's Financial Health

Looking Into A Company's Financial Health

Posted by lionel319 @ Tue 02 Mar, 10,

After looking at all the reasons for investing in a particular stocks (Step #1 - #4), we now look for reasons for NOT investing in a particular stock.

No matter how good the stock's industry is,
No matter how wide the company's moat is,
No matter how good it's growth and profitability is,
If it is sick .... financially, there is no guarantee that it's gonna survive the next wave of influenza.

Ok. So how do I look at a company's financial health?

 



Basically, I look at a company's financial health the same way as I look at a normal person's balance sheet.
These are the 2 golden questions that you should be asking:-

• Is the company capable of paying of it's Short Term Interest(Installment) obligation?
• Is the company capable of paying back it's Long Term Debt?

Let's go through the above 2 points with a case study by looking into a balance sheet of a normal person, a working employee, an engineer, PinkPig, with a net saving of $2000 a month after deducting all basic expenses(food, accommodation, rental, etc)  and other loans (study loan etc).

Let's say, PinkPig just bought a new car, which cost $100k.
He puts up 10% as down payment ($10k), and took a $90k loan from the bank.
He needs to pay $1875/= as monthly installment to the bank.

So far, this is the information that we've got:-

PinkPig's annual savings	$24,000 ($2000 salary x 12 months)
PinkPig's annual Installment obligation	$22,500 ($1875 monthly installment x 12 months)
PinkPig's total Long Term Debt	$90,000 (loan from bank)

Now, let's start drilling into PinkPig's financial health by asking the above 2 golden question, using these financial metrics:-

---

1. Long Term Debt Payback Time

Long Term Debt Payback Time = Long Term Debt / EBIT

This is basically a measure so that we get a feel of whether the company is REALLY capable of paying back all it's debt that it is owing the bank.

For PinkPig's case:-
- PinkPig owes the bank Long Term Debt of $90k.
- PinkPig's Annual Savings (EBIT) is $24k.

If PinkPig were to save up all his annual savings, how long will it take pinkpig to repay the total loan?
$90k / $24k, and we get around 3.75 years.
Anything which spans around 5 years or so is still an acceptable (and comfortable) number for me.
The key to this is just to have a feel whether the company is really capable of repaying back the Long Term Debts if they were to use up all it's Net Income into repaying their loans.
If you want to have a feel of what it looks like, take a look into Ford Motor's Financial Health here. 
In year 2009, Ford had a net income of $2 Billion.
You might say "WOW!!!"
Wait till you take a look at it's Long Term Debt .... which is standing at a whooping $133 Billion.
It takes Ford at least 66 freaking years to pay back it's Long Term Debt, by plowing back all it's net earnings into the bank.
And this is by assuming that Ford is capable of earning $2 Billion year in and year out, no matter what.




2. Times Interest Earned (Interest Coverage Ratio)
 (EBIT = Earnings Before Income-Tax)

PinkPig's Times Interest Earned(TIE) is
= PinkPig's Annual Savings / Annual Installment
= $24,000 / $22,500
= 1.067


The golden question number 1:-

• Is PinkPig capable of paying of it's Short Term Interest(Installment) obligation?

Yes. He is capable. Only if nothing unusual happens to him.
If something were to happen to him, and his saving drop by a mere 10% to  $21,600, he will have problem with that.
Either he will have to sell of something to repay the bank installment, or he will have his car confiscated back by the bank.
This is very crucial to companies, especially those that can't meet their short term debt obligation.
The only way for them to meet this short term obligation is to liquidate their assets, which will in turn eat into their core business, and eventually affect their long term business growth.
We definitely do not want to be put into a nasty situation like that.
Look for a TIE ratio which is pretty high.
The higher the better.
A company which has a TIE ratio of 10x means that it is capable of meeting it's short term obligation even if it's earnings were to drop 10x due to any unforeseen disaster (eg:- economy crisis).
Once a company is seriously wounded, it's really hard for them to be able to regain back their previous glory, not to even mention about fending of competitors and defending their once-used-to-be-market-leader status.
 

http://lionel.textmalaysia.com/looking-into-a-company-s-financial-health.html

Acceptable debt

Is debt bad?  This is a controversial topic!

Although a solid credit record is a good thing for people and businesses to have, it's best for businesses to think in terms of how they can fund their operations from money they make doing what they do.

How do you know when a company has too much debt? 

Generally, if a company has solid cash flow and a  return on investment (ROI) that's significantly greater than the percentage it is paying on borrowed funds, it's probably going to be okay.

A balance sheet loaded with debt will devalue your business over time.  Therefore, if you find that you have to take on debt, treat it as a short-term expense to be extinguished quickly.  (That's not a bad idea for your personal finances, too.)

Debt and Leverage: Financial weapon of mass destruction

When Genius Failed
By Roger Lowenstein

When Genius Failed, by Roger Lowenstein, is the detailed history of the rise and tragic fall of Long-Term Capital Management (LTCM).LTCM was a hedge fund that brought the financial world to its knees when it lost $4 billion trading exotic derivatives.

In its heyday, LTCM was run almost entirely by PhD’s and other extremely high level academics-the best and brightest on Wall Street. Several of its members were Nobel economists- Myron Scholes and Robert Merton. These academics relied heavily upon statistical modeling to discover how markets behave. At first, these models performed beautifully and the fund was up over 30% each year for several years.

Many Wall Street banks became investors as they considered Long-Term to be making riskless profits! Of course this is foolhardy, but blind faith was bestowed upon LTCM because of the pedigree of its creators.

Roger Lowenstein explains how Long-Term became arrogant due to its success and eventually leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.

Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.

By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.

By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.

With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.

What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

http://www.stock-market-crash.net/book/genius.htm

Also read:
http://practical-ta.blogspot.com/?expref=next-blog
http://findarticles.com/p/articles/mi_m1316/is_9_32/ai_65160621/

Moody’s warns of 'social unrest’ as sovereign debt spirals

Moody’s warns of 'social unrest’ as sovereign debt spirals
Britain and other countries with fast-rising government debts must steel themselves for a year in which “social and political cohesiveness” is tested, Moody’s warned.

By Edmund Conway
Published: 7:35PM GMT 15 Dec 2009

Riot police clash with protestors during an anti G20 demonstration near the Bank of England. Moody's has warned future tax rises and spending cuts could trigger more social unrest.
In a sombre report on the outlook for next year, the credit rating agency raised the prospect that future tax rises and spending cuts could trigger social unrest in a range of countries from the developing to the developed world.

It said that in the coming years, evidence of social unrest and public tension may become just as important signs of whether a country will be able to adapt as traditional economic metrics. Signalling that a fiscal crisis remains a possibility for a leading economy, it said that 2010 would be a “tumultuous year for sovereign debt issuers”.

It added that the sheer quantity of debt to be raised by Britain and other leading nations would increase the risk of investor fright.

Strikingly, however, it added that even if countries reached agreement on the depth of the cuts necessary to their budgets, they could face difficulties in carrying out the cuts. The report, which comes amid growing worries about Britain’s credit rating, said: “In those countries whose debt has increased significantly, and especially those whose debt has become unaffordable, the need to rein in deficits will test social cohesiveness. The test will be starker as growth disappoints and interest rates rise.”

It said the main obstacle for fiscal consolidation plans would be signs not necessarily of economic strength but of “political and social tension”.

Greece, where the government has committed to drastic cuts in public expenditure, has suffered a series of riots over the past year which are thought to have been fuelled by economic pressures.

http://www.telegraph.co.uk/finance/economics/6819470/Moodys-warns-of-social-unrest-as-sovereign-debt-spirals.html

LCL Founder Loses Company After Dubai Debt Crisis

Debt and leverage are double-edged swords. You can make it big or you can be decimated. You will never be bankrupt if you are not in debt or excessively leveraged. Always be prepared for the unexpected downsides. Who would have thought that Dubai will be also mained in this financial crisis?

LCL Founder Loses Company After Dubai Debt Crisis (Update3)


By Barry Porter

Dec. 15 (Bloomberg) -- LCL Corp Bhd. Managing Director Low Chin Meng lost control of the Malaysian interior design company he founded after a debt crisis in the Gulf emirate of Dubai forced it to default on loans.

CIMB Islamic Bank Bhd. sold 16 million of Low’s LCL shares, representing his remaining 11.2 percent stake in the business, that were pledged as security against financing, Malaysian stock exchange filings show.

More than of 80 percent of Selangor-based LCL’s sales came from the United Arab Emirates last year compared to 46 percent in 2007, according to data compiled by Bloomberg, as Dubai built the world’s tallest tower and palm tree-shaped islands in a bid to lure international investors.

“When the company was growing at a fast rate it needed short-term capital to meet orders,” Nigel Foo, an analyst at CIMB Investment Bank Bhd., said in a telephone interview from Kuala Lumpur today. “To achieve this Low personally pledged his own shares.”

LCL said Dec. 10 it had been “severely” impacted by financial turmoil in Dubai and defaulted on 72 million ringgit ($21 million) of loans from Affin Bank Bhd. and Bank Islam Malaysia Bhd. because clients in the sheikhdom hadn’t paid bills. State-owned Dubai World roiled markets worldwide Dec. 1 when it said it was in talks with creditors to restructure $26 billion of debt built up during the emirate’s six-year real estate boom.

Bank Debts

LCL had 376 million ringgit of net debt as of Sept. 30, according to a Dec. 11 report by CIMB’s Foo. In addition to loans from CIMB the company borrowed from AMMB Holdings Bhd., Alliance Bank Malaysia Bhd., Bank Muamalat Malaysia Bhd., EON Capital Bhd., Public Bank Bhd., Standard Chartered Plc, Kuwait Finance House and Royal Bank of Scotland Group Plc, according to its Dec. 10 statement.

LCL jumped 8.7 percent today in Kuala Lumpur trading to close at 25 sen, giving the company a market value of 35.8 million ringgit. The stock has plunged 64.5 percent this year.

Low sold blocks of shares in the past three months, reducing his stake to 11.2 percent from 29 percent on Sept. 24, exchange filings show.

Calls to his mobile phone today weren’t answered today and officials at the company’s main office said he wasn’t there when Bloomberg called seeking comment.

Separately, the Malaysian stock exchange said today it reprimanded LCL for not submitting its annual audited accounts on time for the year ended Dec. 31 2008.

To contact the reporter responsible for this story: Barry Porter in Kuala Lumpur at bporter10@bloomberg.net

Last Updated: December 15, 2009 04:23 EST

Quality check to weed out company with an insatiable demand for capital.

Quality check to weed out company with an insatiable demand for capital.

Benjamin Graham and followers placed great emphasis on financial strength, liquidity, debt coverage and so on. It was the tune of the times.

Credit analysis today continue to check all manner of coverage (e.g. interest coverage) and debt ratios, but for most companies reporting a profit, it maybe overkill.

Here are a few checks to provide a margin of safety and a further test of whether the company has an insatiable demand for capital:

1. Are current assets (besides cash) rising faster than the business is growing?

This ties to the asset productivity and turnover measures but it is worth one last check to see whether a company is buying business by extending too much credit.

More receivables result from extending credit.

Losing channel structure and supply chain battles (customers and distributors won't carry inventory; suppliers are making them carry more inventory) result in increased inventories.

In a soft construction environment, distributors and retailers like Home Depot and Lowe's simply aren't taking as much inventory, pushing it back up the supply chain. The main supplier's risk is greater capital requirements and expensive impairments downstream.

2. Is debt growing faster than the business growth?

Over a sustained period, debt rising faster than business growth is a problem.

If the owners won't kick in to grow the business, and if retained earnings aren't sufficient to meet growth, what does that tell you? The business is forced to seek capital.

3. Repeated trips to the financial markets?

If the business continually has to approach the capital markets (other than in startup phases), that again is a sign that internally generated earnings and cash flows are not sufficient.

Once in a while it is okay, but again one is looking to weed out chronic capital consumers.

Assessing indebtedness. How much debt is too much?

Leverage

Leverage and debt assessments are perpetually subjective and are discussed continuously by financial and credit analysts. Some debt is usually regarded as a good thing, for it expands the size of the business and hence the return on owner capital/equity. But too much is too much. Where do you draw the line?

Guiding principles include comparative analysis and vulnerability to downturns. Debt must always be paid back, whether business is good or not - so debt stops being okay when it's too large to cover during a downturn or business strategy change.

Here are a couple of supporting metrics:

Debt to equity

This old standard is common used to get a feel for indebtedness, particularly in comparison with the rest of an industry.

D/E = Total long-term debt / Equity

A company with only $300,000 in long-term debt beyond the portion currently due, against $653 million in equity is virtually debt-free. Such a debt to equity ratio well below 1% is healthy, and so it is for most businesses too. But business analysts may wonder if the company could produce a greater return by borrowing and putting more assets in play. Evidently management has decided that it isn't worth it, so hasn't. That's a better decision than borrowing funds to make the wrong investments.

The investor is left to agree or disagree with management's judgment, but debt-free companies - just like debt-free consumers - come out ahead more often.


Interest coverage

Interest coverage is the ratio of earnings to annual interest, a rough indication of how solvent or burdened a company is by debt.

Interest coverage = Earnings / Annual interest

One way to look at whether a business has the right amount of debt is to look at how much of its earnings are consumed to pay interest on it. (Prudent to keep annual interest less than 20% of earnings.)

When looking at interest coverage, a good question to ask is this: What happens to coverage if, say, business (sales) drops 20%, as in a deep recession?

The ABCs of Screwball Economics

The ABCs of Screwball Economics
By Alyce Lomax April 13, 2009 Comments (2)

We've had TARP (and the return of the TARP), we've had TALF, now we've got the PPIP. Our government's interventions into the economy have come hand in hand with a great propensity for acronyms that are becoming less clever all the time. (I mean, come on, PPIP?)

I've got some great acronyms for what I think these are going to do for our economic situation, but most are not appropriate for our family-friendly site. Here's one that makes it through: SNAFU. Or how about ROFLMAO, if you've got a gallows sense of humor. I still see little possibility that the government's actions are going to help our economic situation in the least.

IPS (It's the price, stupid)

The new PPIP basically fails to admit what more and more people have been arguing, and that is that the major banks like Bank of America (NYSE: BAC), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC) don't have liquidity problems, but rather solvency problems.

There is toxic garbage on their books (and continued lack of transparency on them). The prevailing idea that it's acceptable to price these assets at fantasy levels sounds absurd to me, but the banks want to price these assets at unrealistic levels, and the recent loosening of mark-to-market rules pretty much tells you what you need to know -- somebody wants the fantasy to continue. (Even worse, some are wondering if the banks are just going to sell the assets to one another, with government help.)

The real marketplace wants to price those toxic assets, as low-down and nasty as those prices may be, and doesn't want to pay artificially inflated prices. (Meanwhile, why would we want the government to subsidize purchase of these assets at artificially high prices anyway?). Suffice it to say, it doesn't follow that prices should be whatever these companies decide they should be and the government should support that.

IDS (It's the debt, stupid)

The government's programs have been geared toward stimulating lending again. But here's the thing that's been driving me crazy for ages: There's a heck of a lot of indebtedness in our system already; it's part of the problem, and that goes for corporations, consumers, and our government itself.

Of course, the government wants to kick up lending again. Our past economic growth was based on an artificial daisy chain fed into by bubbly asset prices, low interest rates, and the inevitable loads and loads of debt being taken on. Of course, this has to correct because if you really think about it, it's been utterly unsustainable, but nobody wants to take the inevitable medicine. The smart consumers and companies that didn't dig themselves into massive debt holes probably don't want to borrow right now. So, who's left?

Consumers were melting the MasterCard (NYSE: MA) and Visa (NYSE: V) cards buying up Coach (NYSE: COH) handbags and Tiffany baubles, or flat-screen TVs or Sirius XM (Nasdaq: SIRI) radios. Unfortunately, we can now gather that a heck of a lot of their spending wasn't based on real income, but rather subsidized by debt or taking equity out of their bubbly priced homes. Now many consumers are busted broke, with slashed credit lines, defaulted loans, and lost jobs. Should they borrow more?

Meanwhile, many corporations loaded up on debt, too. I remember thinking it was weird for companies to take on debt to say, pay dividends or buy back shares (much less to finance their operations). Back then, it made sense to just about everybody, and everybody was doing it. But now? It's pretty clear that many companies weren't concerned about a rainy day coming, a day when it might become difficult for them to service that debt. Well, it's come. Should they borrow more?

IES (It's the economy, stupid)

It's morally reprehensible that the government should expect already overly indebted consumers to keep on borrowing to reinflate our deflating economy. Some of us are concerned that our economy has been an accident waiting to happen, given the fact that consumer spending represents 70% -- the lion's share -- of GDP. The emphasis on services and the financial industry's love for pushing pieces of paper around has put us in a precarious position indeed, as has the emphasis on debtor spending to make our economic world go round.

Meanwhile, it looks like my fears of a zombie apocalypse economy are coming to pass. Throwing good money after bad not only robs taxpayers, but it also robs healthy companies of capital as the zombies are kept alive. Propping up losers means that soon, all we'll have are losers, and an awfully big bill to pay.

BBIAF, with more bad acronyms

There are many arguments emanating from many different schools of thought about what to do. I've always thought that the government should stay out of this so we could have a difficult, but likely shorter lived, correction, clear out the artificial excess, and get to work on moving back to an economy with real innovation and truly healthy businesses -- all the while leaving bubbly fakery behind.

I know many people don't agree with my point of view, but it seems like more and more people from many different economic camps are starting to come around to the idea that the fixes from government intervention from both the previous administration and the current one are simply helping politically connected bankers and doing little to actually fix what ails the real economy. The word "oligarchy" seems to be cropping up an awful lot, in fact.

Let's hope that the next acronym program won't be one that denotes being completely out of luck, but after endless government interventions that don't seem to help and seem more likely to hurt, it's starting to feel like that's our destiny. Let's hope not.


Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy.

http://www.fool.com/investing/general/2009/04/13/the-abcs-of-screwball-economics.aspx

How to pay off your debts

Afghan horsemen play Buzkashi on the outskirts of Kabul. Buzkashi is the national sport of Afghanistan, which literally translated means "goat grabbing". A headless carcass is placed in the centre of a circle and surrounded by players of two opposing teams. The object of the game is to get control of the carcass and bring it to the scoring area
(Rafiq Maqbool/AP)

-----

From Times Online
January 31, 2008

How to pay off your debts
James Charles

We would all like to bury our heads in the sand when it comes to debt, but the stark reality is that the longer you leave it, the worse your situation will become, so act now. There are a number of simple steps that you can take to tackle the problem head on and get back in the black.

Prioritise
Work out which debts you need to address first. Some will be more urgent, while others, such as a student loan, can be cleared over a longer period of time. You could divide them into two groups: priority and non-priority. Mortgage repayments, for example, would be considered priority debts because failing to make your repayments could result in you losing your home.
Whether you want to tackle the smallest, largest, most expensive or cheapest debt first, it is vital that you keep up the minimum repayments on all debts. Not doing so can damage your credit score and reduce the chance of obtaining credit in the future.

Background
How to improve your credit rating
How to choose a credit card
How to pay off your debts
IVAs explained
Student loans explained
Related Links
Store card interest 'extortionate'
1.7m households request debt help
Fight back against rising interest rates

Budget
To help to work out how much spare cash you can devote to repaying debts, it is crucial that you draw up a budget.
You can use a budget calculator online or simply sit down with an old-fashioned pen and paper and list all your income and outgoings. Then try to cut back where you can and keep a lid on costs wherever possible.

Boost
A simple and obvious way to speed the process of clearing your debts is to raise your monthly payments, and there are lots of ways to get the extra money you will need to do it.
The possibilities are almost endless, from renting your driveway to selling your old mobile phone. You could try selling unwanted presents or gadgets on eBay or other auction sites.
It is also worth making sure that you are not due any tax credits or government benefits.
Check that you are on the best deals for your insurance, loans, mortgages and credit cards by using price comparison websites such as Moneyfacts.co.uk or moneysupermarket.com, Also check whether you are paying for loan insurance on your mortgage or other credit and decide whether you really need this cover.

Savings
If you have a pot of savings locked away for emergencies, consider using the money to clear debt. It is likely that the cost of your debts is more than the return on your savings.

Snowballing
Once you have organised your debts, you may want to look at clearing them through a process of snowballing.
This involves making the minimum payments on your debts but using any extra cash to pay off one of them. Once you have finished clearing this first debt, you should then focus on the second debt, using the same extra cash, plus the money that you were using to make the minimum payment on the first debt. Then simply continue this process until all your debts are cleared.

Consolidate
If you are overwhelmed by the number of different debts you have, it may be worth consolidating your debts into one large loan.
The most common way of doing this is to move all your credit card balances to a new card with a 0 per cent rate for balance transfers.
But be careful if you decide to take out a consolidation loan. They can be expensive in the long term and may be secured on your home.

Communicate
Having relatively small amounts of debt is now extremely common. The average UK adult owes £29,500, including mortgages, so you are certainly not alone. However, if you are struggling to make repayments, or you are feeling overwhelmed by your situation, seek help from a debt charity.
Also try speaking to your lender. It may be willing to make an agreement over a new repayment timetable. You could also speak to a debt management company. And if you are really stuck, you could consider an individual voluntary agreement or even, as a very last resort, bankruptcy.

http://www.timesonline.co.uk/tol/money/reader_guides/article3247171.ece

Avoid This Triple Whammy to Your Wealth

Avoid This Triple Whammy to Your Wealth
By Dan Caplinger
March 13, 2009 Comments (1)

In the latest installment of our series on government reports that make you say "duh," the Federal Reserve announced today that on the whole, American households were poorer at the beginning of 2009 than they had been the previous year.
That's not news to anyone. But the key lesson you should take from the report may not be so obvious. While falling real estate values and dropping stock prices are mostly beyond your control, you can help reverse the trend of falling net worth by focusing on the one thing you can do to improve your finances: cutting your debt.

Some ugly numbers
The Federal Reserve's flow of funds report typically makes great reading material if you're short on sleeping pills. But recently, those with a morbid sense of curiosity have pored through the document looking for further proof of just how bad the current economic climate really is.
The most recent release doesn't disappoint on that score. Total assets amounted to $65.7 trillion at the end of 2008, down nearly 8% in just the fourth quarter and almost 15% for the year. As you'd probably expect, the losses spanned across household balance sheets -- real estate values fell about 11% in 2008, while financial assets dropped 18%.
On the liability side, although households' overall debt levels finally ended a streak of large annual gains, they certainly failed to shrink significantly, clocking in at $14.2 trillion. Mortgage debt fell very slightly, but consumer credit more than offset those losses.
The net result was an $11 trillion loss in net worth, to $51.5 trillion. That's an 18% drop just since last year and the lowest level since 2003, representing the undoing of five years' worth of appreciating wealth for American households.

Impact on business
Even worse, though stable debt levels may not sound like great news, they're having a huge negative impact on businesses that count on consumer or corporate spending -- in other words, just about the entire economy. Here's just a sample of warnings about first-quarter earnings that companies have announced so far this year:

Company
Date Announced
Growth Estimate for Current Quarter
Growth Estimate for Next Quarter

Applied Materials (Nasdaq: AMAT)
Feb. 2
(141.7%)
(157.1%)
Procter & Gamble (NYSE: PG)
Jan. 30
(1.2%)
(10.9%)
Novartis (NYSE: NVS)
Feb. 24
(18.6%)
(20.4%)
Intel (Nasdaq: INTC)
Jan. 19
(92.0%)
(78.6%)
Adobe (Nasdaq: ADBE)
March 4
(8.3%)
(30.0%)
Source: Company press releases and Yahoo! Finance.

In addition, the debt freeze among consumers could spell more danger ahead for companies that rely on debt financing for sales, including homebuilders like Pulte Homes (NYSE: PHM) and high-end electronics and appliance seller Best Buy (NYSE: BBY).

How to keep getting richer
Unfortunately, out of the three main areas the report identifies, you can't do much about two of them. Real estate prices won't set a bottom until they're good and ready, and most homeowners have little choice but to sit and wait for a recovery. Similarly, investors in stocks have seen big losses, and while this week's bounce in stocks has been encouraging, it's likely that there will be more volatility before stocks establish a strong foundation for more extensive gains.
What you can do, however, is to do your part to keep the other side of your personal balance sheet in line. Although some may blame rising savings rates for continued weakness in the economy, that's no excuse for you to maintain irresponsibly high debt levels for yourself.
If you dedicate yourself to reducing debt and keeping your savings levels up, then you'll be better able to weather a storm of decreasing asset values. Although you still may not see your net worth recover to year-ago levels in the near future, keeping debt under control will make that eventual recovery a lot faster -- and easier to achieve.


Read more about how to keep your finances healthy:
Four ways you may be destroying your retirement.
Where smart investors are putting their money today.
Don't rely on this retirement plan.

Fool contributor Dan Caplinger has mostly stayed out of debt, at least for now. He doesn't own shares of the companies mentioned in this article. Novartis is a Motley Fool Global Gains pick. Procter & Gamble is a Motley Fool Income Investor recommendation.

http://www.fool.com/retirement/general/2009/03/13/avoid-this-triple-whammy-to-your-wealth.aspx

Small-Business Financing: Debt vs. Equity

Summary

• Since debt and equity are accounted for differently, each has a different impact on earnings, cash flow and taxes, and each also has a different effect on leverage, dilution and a host of other metrics.
  
• Debt can be a loan, line of credit, bond or even an IOU -- any promise to repay borrowed amounts over a certain time with a specified interest rate and other terms.
  
• When you finance with equity, you are giving up a portion of your ownership interest in -- and control of -- the company in exchange for cash.
  
• While equity financing can be used for many different purposes, it is usually used for long-term general funding and not tied to specific projects or time frames.
  
• The mix of debt and equity that best suits your company will depend on the type of business, its age, and a number of other factors.

DEBT-TO-CAPITAL RATIOS FOR SELECTED INDUSTRIES
Publishing 34%
Homebuilding 37%
Advertising & Marketing 37%
Lodging & Gaming 56%
General Retailing 24%
Supermarkets & Drugstores 33%
Commercial Transportation 18%
Packaged Foods 27%
Restaurants 23%
Health Care: Managed Care 20%
Movies & Home Entertainment 17%
(Source: Standard & Poor's.)

Source:
http://finance.yahoo.com/how-to-guide/career-work/12825
Topics
Small-Business Financing: Debt vs. Equity
Debt
Equity
Striking a Balance

Additional comments:

Yahoo! Finance User - Wednesday, May 28, 2008, 11:37AM ET Report Abuse
Overall: 4/5
Nice overall article. Loan terms depend on what is being pruchased. Real estate (10 to 20 yrs), equipment (3 to 7 yrs), inventory (2 to 3 yrs), etc. An SBA backed loan can help lengthen these terms which will help decrease monthly payments.

**Debt deflation is tightening its grip over the entire global system.

Deflation virus is moving the policy test beyond the 1930s extremes
Debt deflation is tightening its grip over the entire global system. Interest rates are creeping towards zero in Japan, America, and now across most of Europe.

By Ambrose Evans-Pritchard, International Business EditorLast Updated: 5:50AM GMT 09 Dec 2008
Comments 187 Comment on this article

China will not lift us out - they are the most vulnerable of all Photo: AP
We are beyond the extremes of the 1930s. The frontiers of monetary policy are being pushed to limits that may now test viability of paper currencies and modern central banking.
You cannot drop below zero. So what next if the credit markets refuse to thaw? Yes, Japan visited and survived this policy Hell during its lost decade, but that was a local affair in an otherwise booming global economy. It tells us nothing.
This time we are all going down together. There is no deus ex machina to lift us out. Certainly not China, which is the most vulnerable of all.
As the risk grows, officials at the highest level of the British Government have begun to circulate a six-year-old speech by Ben Bernanke – at the time of its writing, a garrulous kid governor at the US Federal Reserve. Entitled Deflation: Making Sure It Doesn’t Happen Here, it is the manual of guerrilla tactics for defeating slumps by monetary means.
“The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost,” he said.
Critics had great fun with this when Bernanke later became Fed chief. But the speech is best seen as a thought experiment by a Princeton professor thinking aloud during the deflation mini-scare of 2002.
His point was that central banks never run out of ammunition. They have an inexhaustible arsenal. The world’s fate now hangs on whether he was right (which is probable), or wrong (which is possible).
As a scholar of the Great Depression, Bernanke does not think that sliding prices can safely be allowed to run their course. “Sustained deflation can be highly destructive to a modern economy,” he said.
Once the killer virus becomes lodged in the system, it leads to a self-reinforcing debt trap – the real burden of mortgages rises, year after year, house prices falling, year after year. The noose tightens until you choke. Subtly, it shifts wealth from workers to bondholders. It is reactionary poison. Ultimately, it leads to civic revolt. Democracies do not tolerate such social upheaval for long. They change the rules.
Bernanke’s central claim is that the big guns of monetary policy were never properly deployed during the Depression, or during the early years of Japan’s bust, so no wonder the slumps dragged on.
The Fed can create money out of thin air and mop up assets on the open market, like a sovereign sugar daddy. “Sufficient injections of money will ultimately always reverse a deflation.”
Bernanke said the Fed can “expand the menu of assets that it buys”. US Treasury bonds top the list, but it can equally purchase mortgage securities from US agencies such as Fannie, Freddie and Ginnie, or company bonds, or commercial paper. Any asset will do.
The Fed can acquire houses, stocks, or a herd of Texas Longhorn cattle if it wants. It can even scatter $100 bills from helicopters. (Actually, Japan is about to do this with shopping coupons).
All the Fed needs is emergency powers under Article 13 (3) of its code. This “unusual and exigent circumstances” clause was indeed invoked – very quietly – in March to save the US investment bank Bear Stearns.
There has been no looking back since. Last week the Fed began printing money to buy mortgage debt directly. The aim is to drive down the long-term interest rates used for most US home loans. The Bernanke speech is being put into practice, almost to the letter.
No doubt, such reflation a l’outrance can “work”, but what is the exit strategy? The policy leaves behind a liquidity lake. The risk is that this will flood the system once the credit pipes are unblocked. The economy could flip abruptly from deflation to hyper-inflation.
Nobel Laureate Robert Mundell warned last week that America faces disaster unless the Bernanke policy is reversed immediately. This is a minority view, but one held by a disturbingly large number of theorists. History will judge.
Most central bankers suffer from a déformation professionnelle. Those shaped by the 1970s are haunted by ghosts of libertine excess. Those like Bernanke who were shaped by the 1930s live with their Depression poltergeists.
His original claim to fame was work on the “credit channel” causes of slumps. Bank failures can snowball out of control as the “financial accelerator” kicks in. The cardinal error of the 1930s was to let lending contract.
This is why he went nuclear in January, ramming through the most dramatic rates cuts in Fed history. Events have borne him out.
A case can be made that Bernanke’s pre-emptive blitz has greatly reduced the likelihood of a catastrophe. It was no mean feat given that he had to face down a simmering revolt earlier this year from the Fed’s regional banks.
The sooner the Bank of England tears up its rule books and prepares to follow the script in Bernanke’s manual, the more chance we too have of avoiding a crash landing.
Monetary stimulus is a better option than fiscal sprees that leave us saddled with public debt – the path that nearly wrecked Japan.
Yes, I backed the Brown stimulus package – with a clothes-peg over my nose – but only as a one-off emergency. Public spending should be a last resort, as Keynes always argued.
Of course, Bernanke should not be let off the hook too lightly. Let us not forget that he was deeply complicit in creating the disaster we now face. He was cheerleader of Alan Greenspan’s easy-money stupidities from 2003-2006. He egged on debt debauchery.
It was he who provided the theoretical underpinnings of the Greenspan doctrine that one could safely ignore housing and stock bubbles because the Fed could simply “clean up afterwards”. Not so simply, it turns out.
As Bernanke said in his 2002 speech: “the best way to get out of trouble is not to get into it in the first place”. Too late now.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3629806/Deflation-virus-is-moving-the-policy-test-beyond-the-1930s-extremes.html

Federal Reserve battles debt and deflation

Federal Reserve is damned either way as it battles debt and deflation
We know what causes a recession to metastasize into a slump. Irving Fisher, the paramount US economist of the inter-war years, wrote the text in 1933: "Debt-Deflation Theory of Great Depressions".

By Ambrose Evans-PritchardLast Updated: 6:34PM GMT 18 Dec 2008
Comments 66 Comment on this article
"Such a disaster is somewhat like the capsizing of a ship which, under ordinary conditions is always near stable equilibrium but which, after being tipped beyond a certain angle, has no longer this tendency to return to equilibrium, but a tendency to depart further from it," he said.
Today we call this "Gladwell's tipping point". Once it goes, you can't get back up. This is why the Federal Reserve has resorted to emergency measures that seem mad at first sight.
It has not only cut rates to near zero for the first time in US history, it is also conjuring $2 trillion of stimulus out of thin air. This is Quantitative Easing, or just plain 'QE' in our brave new world.
The key is the toxic mix of high debt and deflation. An economy can handle one at a time, but not both.
The reason why it "departs further" from equilibrium is more or less understood. The burden of debt increases as prices fall, creating self-feeding spiral. This is what Fisher called the "swelling dollar" effect. Real debt costs rose by 40pc from 1929 to early 1933 by his count. Debtors suffocated to death.
Brian Reading from Lombard Street Research has revived this neglected thesis and come up with some disturbing figures. US household debt is now $13.9 trillion, down just 1pc from its peak last year. Meanwhile household wealth has fallen 14pc as property crashes, a loss of $6.67 trillion. The debt-to-wealth ratio is rocketing.
Clearly the US is already in the grip of debt-deflation. "The obvious conclusion is that the Fed should print money to purchase private sector assets so as to drive up their price," he said.
Fed chief Ben Bernanke does not need prompting. He made his name as a Princeton professor studying the "credit channel" causes of depressions. Now fate has put him in charge of the channel.
Under his guidance, the Fed has this week pledged to "employ all available tools" to stave off deflation - and damn the torpedoes. It will purchase "large quantities of agency debt and mortgage-backed securities." It will evaluate "the potential benefits of purchasing longer-term Treasury securities," i.e, printing money to pay the Pentagon.
Put bluntly, the Fed is deliberately stoking inflation. At some point it will succeed. Then the risk flips quickly to spiralling inflation as the elastic snaps back. There will be a second point of danger.
By late 2009, if not before, the bond vigilantes may start to fret about the liquidity lake. They will worry that the Fed may have to start feeding its holdings of debt back onto the market. The Fed's balance sheet has already risen from $800bn in September to $2.2 trillion this month. It will be $3 trillion by early next year.
"The bond markets could go into free fall," said Marc Ostwald from Monument Securities.
"The Fed went into this all guns blazing just as the Neo-cons went into Iraq thinking it was a great idea to get rid of Saddam, without planning an exit strategy. As soon as we get the first uptick in inflation, the markets are going to turn and say this is what we feared would happen all along. Then what?" he said.
New Star's Simon Ward said all three measures of the US broad money supply are flashing recovery. M2 has risen at annual rate of 17pc over three months.
"It has all changed since the Fed began buying commercial paper in October. If the money supply is booming at 20pc in six months, inflation will become a concern. Given that public debt ratios are already on an explosive path, we risk a debt trap," he said.
For now, the bond markets are quiet. Futures contracts are pricing five years of deflation in the US. Yields on 10-year US Treasuries have halved since early November to 2.09pc, the lowest since the Fed's data began. Three-month dollar LIBOR has plummeted to 1.53pc.
It is the same pattern across the world. 10-year yields have fallen to 1.27pc in Japan, 3pc in Germany, 3.2pc in Britain, and 3.49pc in France.
The bond markets seem to be betting that emergency action by central banks will take a very long time to work, if it works at all. By cutting to zero, the Fed has come close to shutting down the US 'repo' market that plays a crucial role in providing liquidity. It has caused havoc to the $3.5 trillion money markets - as the Bank of Japan, burned by experienced, had warned. It has become even harder for banks to raise money. Some argue that extreme monetary policy is already doing more harm than good.
Mr Bernanke is known for his "helicopter speech" in November 2002, when he nonchalantly talked of the Fed's "printing press" and said it was the easiest thing in the world to "reverse deflation."
Less known is his joint-paper in 2004 - "Monetary Policy Alternatives at the zero-bound". By then doubts were creeping in. He admitted to "considerable uncertainty" as to whether extreme tools will actually work. Liquidity could fail to gain traction.
Put another way, the Fed is flying by the seat of its pants. It should never have let debt grow to such grotesque levels in the first place.

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/3834108/Federal-Reserve-is-damned-either-way-as-it-battles-debt-and-deflation.html

Buying Stocks on the Verge of Bankruptcy

QUESTION: Why is it that investors are buying stocks in companies that are on the verge bankruptcy like AIG (AIG: 1.60, -0.07, -4.19%) and General Motors (GM: 4.49, +0.83, +22.67%)? Is there any benefit to buying at this price, and what would be the worst-case scenario of my investment?
--Mike Ghazala

ANSWER: Let's get right to the point: The worst-case scenario is you lose your entire investment. When a company files Chapter 11 the business is reorganized, but there's no guarantee shares will be worth anything once the company emerges from bankruptcy protection. Ditto for a Chapter 7 bankruptcy liquidation, in which a company's assets are sold off. Rules governing corporate bankruptcies generally dictate that secured and unsecured creditors -- banks, bondholders and the like -- get paid off first. Stockholders are last in line, and often there's nothing left by the time their turn comes around. If there are assets remaining, stockholders may receive shares in the newly reorganized company.

So why do investors buy shares of companies on the verge of bankruptcy?

Some may truly believe the company will avoid disaster and bounce back, making the shares an attractive long-term investment.

More often than not, though, investors are looking to make a quick buck on a short-term trade. In that case fundamentals are thrown out the window. Hedge funds and institutional trading desks are often involved in highly leveraged trades of these extremely volatile stocks. With such heavy hitters in the game, and so much uncertainty surrounding the companies, we recommend that individual investors keep their distance.

One other note: Even in bankruptcy a company's shares may continue to trade, often for pennies apiece. While the low price might be tempting, liquidity is spotty because the stocks are usually forced to trade over the counter rather than on a major exchange like the NYSE.



http://www.smartmoney.com/personal-finance/college-planning/financial-crisis-answer-center/?cid=1108