Sunday, November 21, 2021

No Fluff 2 - Balance sheet - Debt

 Hello again!

Apologies to the 2 people following this blog, I had been doing quite a bit of marie kondo in my life the last couple of months.

Anyway, today I shall be writing about the balance sheet of companies I invest in.

At a minimum, I prefer companies with little or no debt and I like to reference the debt to equity ratio here as a guideline - a company with 0 is stellar, between 0 and 0.5 is alright, 0.5-1.0 warrants a real understanding of the type of debt it has and regular monitoring to see if it can control it. Above 1.0, well I'd say you're living life in the fast lane.

Now, I have nothing against debt - I mean, a credit card is the most common and useful debt in our daily lives. You, literally on your phone now, can buy just about anything in the world with the swipe of your thumbprint. You use it for both needs and wants, well most of it anyway. You swipe/charge it to your credit card and (hopefully) settle the balances in full when the bill comes. But what if you don't settle in full? well, you make the minimum monthly payments and the banks will OK your account; you can continue spending as long as you meet that minimum amount every month (there's of course a whole bunch of reasons to avoid the minimum amount but that's for another time). What if you get a little behind in payments? Well then, the banks charge you a late fee and also make a note of this in CCRIS/CTOS. Get a little behind too much and you run the risk of card cancellation, getting into default, getting hit with legal action by the bank, getting blacklisted and not being able to travel out of the country - talk about a fast escalation.

Now, think of the parallels between the credit card in your life and debt in a company:

A company with money financed by debt can expand quickly, by building up factories/plants/production capabilities at scale, marketing, building a brand and selling to more customers around the globe eg you on the phone with your thumb, ready to scan hehe. If it works out well, great - the profits can cover the interests and repay the principal. If it doesn't, well that's the tricky bit since a company usually has what is called a debt covenant with its lenders and most of the time, paying interest and principal repayments according to the schedule is something that forms part of the covenant. So, whether you're making money or not, you gotta make those payments regularly. Failure to do so, well same like the last bit with a credit card, you run the risk of getting into default, getting hit with legal action by the bank, getting delisted, having to sell everything in the company to pay the banks and whoever else the company might have owed money to. 

Like Peter Lynch said, a company without debt would have to do something deserving of a distinguished award to go out of business. And if you think about it, you can always negotiate a way to defer expenses and payments to your various suppliers like utilities, wages, insurance, and so on, because, you can always reason if you go out of business you can't pay them anyway so it's in everyone's interest that you defer that payment for future income so all the players in the game gets paid. Banks on the other hand.. and by banks, I mean creditors and banks but really, it is whoever loaned you money; if they will it, they'll take you to court in the event of a default and you wind up liquidating everything to pay them. So again, debt, like visceral fat, can be a real killer.

Nowhere else in my adult life have I seen and understood the phrase, "Only when the tide goes out do you discover who's been swimming naked" than in the last 2 years. During the first few months of the lockdown in Malaysia back in 2020, many companies shuttered, with hotels being the stellar (well, terribly stellar)  example of this - many a hotel, whether boutique, break and breakfast, inns, even the large multinational ones closed shop, never to be resurrected again. All this in the span of like what, 3 months?

So, in short, less debt is always best. Although, there are always exceptions to a rule; like when interest rates are as low as baggy pants were in the 2000s in the sub 2% or if the company has large amounts of cash or a strong cashflow.

No comments:

Post a Comment