Hello fellow fools. I have come to a quandry. I am confused by listening to the experts, Buffet, Lynch, Neff and Tom and David in regard to cash flow and debt. When is taking on an enormous amount of debt okay outside of rule breakers? According to the experts the answer is never but yet I see a lot of people still think that SBC, LU, and ISCA are all great companies. According to the cash to debt ratio these companies should all suffer in a rising interest rate environment. Am I missing something. Please explain. ALso another rule maker Phizer has added quite a bit so when is too much debt too much? If anyone can relate this to the annual report on ISCA that would be most helpful since that is where my confusion all started. I understand they want to own all the tracks but did they jump in too much too quickly or no? Thank you for the help. Sincerely,Greg
Greg --This is a somewhat simplistic response to your quetion, but it's a little piece I prepared for our weekly syndicated newspaper feature (for info on how to get it into your local paper: http://www.fool.com/specials/1999/sp991117paper.htm)It might offer some insights for you or some others.SelenaThe Fool SchoolDebating DebtMany investors think that debt on a company's balance sheet is a red flag. In truth, though, debt can be both bad and good. First, the bad. If a company is saddled with a lot of debt, it's locked into interest payments that it must make. If it doesn't have the cash to cover these at any point, it's in deep doodoo. Many individuals can probably relate to this, having experienced the dark side of debt when racking up charges on credit cards. Now, the good. Consider that most people would never be able to buy their homes without debt. Without car and school loans, many of us would probably be driving used cars and taking correspondence courses we found on matchbook covers. Debt can be a boon for businesses, too. Many great companies, such as Federal Express and the Walt Disney Co., came to life because of early loans to their founders. Established companies can make good use of debt, as well, borrowing to expand operations and grow business. Interest payments also decrease a company's taxable income, as they're deductible. Investors willing to consider companies with debt need to evaluate whether the debt taken on is manageable and whether the capital raised and invested is earning more than it costs. Perhaps you're worried about the debt load of Fingernail-on-Blackboard Car Alarm Co. (ticker: AIEEE). Glance at the notes in the annual report and you may find that the effective interest rate for its debt is just 5 percent. If AIEEE is putting the borrowed funds to work earning say, 8 percent, then things aren't so bad. When companies need money, they typically have two main choices: They can issue more stock or debt. Issuing stock can dilute the value of existing shares. Issuing debt can sometimes be more efficient, as its after-tax cost can be much cheaper than equity. All things being equal, though, we prefer to see little debt on a balance sheet. Companies that can grow without using debt or issuing extra stock are in a more powerful position than other firms. Still, you needn't balk at the first sight of debt. Just evaluate it carefully.
In addition to the excellent reply from TMFSelena I would like to add the following comments relevant to International Speedway Corporation (ISCA). disclaimer - I only spent about 15 minutes with their 10K so do not construe this to be a thorough analysis. If you are serious about this company, it would be prudent of you to double check my anlaysis and dig into the resaons for taking on the debt this year. This appears to be a very conservatively financed company whose debt situation would not concern me as an investor.While they increased their debt in 1999 the current portion of LTD is still on 2,655. Meanwhile their cash + short tern investment are 38,501. Even if they had a disastrous year, they would have no problem paying the interest on their debt this year, and probably the next, and probably the next.Their debt / equity ration is farily conservative. While they have long term debt of 496,067 their shareholder's equity is over twice as much. This shows a company that is financed principally on shareholder's equity and not overly leveraged. Looking at the income statement their interest expense for 1999 was 2.3. Meanwhile their income before taxes was 31.9. This is another sign that their income is sufficient to cover the debt payments and they can afford a substantial drop in income before servicing the debt becomes a problem.
Hi Greg,The question of how much debt is too much is a tough one. I would refer you to Graham & Dodds book Security Analysis, chapter 40 on Capitalization Structure.The gist is;"...frequently the stockholders will be better off if the company has a moderate amount of debt than if it has none.""However, one of the effects of a highly leveraged capital structure is to make the market value of the enterprise highly unpredictable.""That damage done by excessive debt needs no argument, and the history of our railroads points up that moral only too well. But it would be naive to assume from such examples, that all corporate debt is bad and to be avoided. If that were so, the only companies that would deserve good credit would be those that never borrowed.""In our view the question whether corporate borrowing is desirable or undesirable is to be decided not as a matter of general principle but by reference to the circumstances of the case. For some companies it is dangerous to owe more than a nominal amount ; hence not enough money could be soundly borrowed to make the transaction worthwhile.""In the case of nonutility enterprises the soundness of the debt structure cannot be judged by reference to the book value of the stock equity, since there is no assurance that earnings will be commensurate with the book investment.Thus the primary criterion of sound borrowing is not the balance sheet but the income account over a number of years past and a businesslike appraisal of the hazards of the future."It seems like Graham & Dodd view debt as a factor that if things go well and debt is moderate can add value to a company but if debt is too high and/or things go poorly can greatly reduce or eliminate the value for stockholders. The key variables would seem to be making sure that the income stream can support the payment of interest & principle over time even in mediocre or poor business environments.ZB
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