How to Analyze the Debt of a Company


Hi, I’m Jimmy and this video we’re looking at how we can analyze the debt of a company. So I’m sure that most of us know that interest rates have been dropping. And as we could guess, many companies have taken out more debt, in some cases a lot more debt because of those falling interest rates. Now, this is not always a bad thing. Sometimes if you take out some additional debt and let’s say you’re paying 4 percent of that debt, we can grow the company by 10 percent or 8 percent. That’s a logical thing to do, assuming you can manage the debt. So let’s look quickly at how the debt affects a company and where we can find the impact of that debt on different financial statements and ultimately what it could mean for those companies. What are the risks? What benefits? And hopefully we can use this information to get us closer to our personal goal of achieving financial independence. Okay. Now, I did a video a while back where I tried to walk through how to calculate the fair value of a company using a discounted cash flow valuation technique. Here’s a link in the description below, if you’re curious. But the reason that I bring that out in this video is that in that video I used Apple, the company, as our example to sort of examine how we can come up with a calculation. And since then, I’ve gotten quite a few questions as to how I came up with their debt numbers. I figured I could use Apple as our example once again in this video and simultaneously hopefully clear up where I got those debt numbers from sort of two birds, one stone. OK. Sorry. So let’s kick it off. So this is Apple’s balance sheet from the last annual report. And as we could see, well, they’re showing both numbers for twenty nineteen and for twenty eighteen. We’re mostly going to focus on the twenty nineteen numbers since those are the most recent numbers, most recent annual numbers. But when I reference the DCF video we’re going to be looking at the twenty eighteen numbers. OK, so first let’s look at how the balance sheet is broken up and as we could see, all balance sheets are broken into. Three main sections, assets, liabilities and then shareholder equity. OK, simple enough. So the most popular type of debt is when a company takes out of bond or the issue of bond power to the public wherever it goes. And that’s mostly where we’re going to focus on now. Many investors know that liabilities represent what the company owes, but a few times I’ve seen liabilities mistaken for debt. And just so we’re on the same page, liabilities and debt are not the exact same thing. So they’re not really the same thing as an example. Each of us have our own households, our own personal family, whatever it is. Let’s imagine that we have a Netflix account. Well, if we have a Netflix account, that is a bill that we owe each month. But I wouldn’t really qualify. That is debt, although that would show up in the accounts payable section of the liability. So it is a liability, but it is not the same thing as debt. So that’s just an example. What we’re really looking for here is we’re looking for term debt that falls into both the current liability section and the non-current liability section. Now, just so we’re all on the same page. Current liabilities are are items owed by the company within the next 12 months. Within the next 12 months. Anything beyond that is non-current liabilities. So this term debt is the debt from that Apple owes from the bonds that they’ve issued. And if we’re curious for the DCF video, this is where I got their total debt numbers from. I added up the short term portion of their debt, of their term debt and the long term portion of their term debt. And I use that to calculate Apple’s total debt. OK, so now we know this is where the bond show up and the balance sheet. But let’s look a bit closer, because bonds actually affect all three financial statements. OK, so just to illustrate, let’s imagine that Apple went ahead and they issued 100 million dollars in new bonds. Well, that hundred million dollars would fall right here on their on their balance sheet. But because they sold 100 million dollars in debt, they also received a hundred million dollars in cash. That cash would appear appear on their balance sheet. Two sides are in balance because one hundred million went to both assets and liabilities. OK. Now let’s jump over the cash flow statement. So once again, cash the cash flow statement is divided into three different sections. Very similar to the balance sheet. The top section focuses on cash spent and generated from the normal operations of the business. Then we have cash flow from investing that focuses on the sale and purchase of maybe buildings or if they bought stock in another company or they sold it, or if they were, let’s say they replaced a roof of one of their own manufacturing plants. Well, that would fall into the cash flow from investing parts, since in that case they would be investing in themselves. OK, simple enough. Then we jump down to the third and final section cash flow from financing. And this is where we are going to focus. So this section is clearly where the new one hundred million dollars that Apple just issued in bonds. Would appear. And if we’re curious, it would appear right on this line item titled Proceeds from the Issuance of term debt. OK. Logical. Now, if they paid off debt, then would appear in this number. So as you can see, we start to get this story coming together and understanding these different line items from just from debt is a smart thing to pay attention to. So if they issued stock, well, that would appear here. And if they issued dividend payments, that would appear there. So the financing should section of the cash flow statement tells us how the company raises money or pays back money, anything like that would end up in this section. OK. Now, this brings us to the income statement. And this is also where we can see the impact of debt in general on profits or earnings per share or price to earnings ratios. Now, this is where this one Apple’s income statement looks like. And when I was prepping for this video is actually scratching my head for a second because I knew that I was looking for a line item called interest expense. And clearly, we don’t see that when it should appear right in this section. Now, as I read through each of these line items from this section, the only logical place that interest expense could be hiding is in other income slash expenses. So I went ahead, check the footnotes. And if we ever can’t find something that, you know, should be there many times, many, many times the footnotes is where we will find it. I happened to find this in footnote number seven. And now, as we could see, Apple’s interest expense is about $3.6 billion. And this is where it gets interesting. So our question is, is that too much debt? Well, if I saw personally nothing but this one footnote, I can make a fairly educated guess. I can be fairly confident about my guess that an apples case, this is not too much debt. In fact, I can also guess that they must have a ton of cash and short term investments since their interest in dividend income is almost 5 billion dollars. So basically their interest in dividend income in this case is bringing in more than Apple’s interest expense. So this is a great position for any company to be in. Now, to get a bit broader about a company’s debt in general, to drift away from the apple in isolation. How do we know if a company’s debt is, let’s call it manageable? So for that, we can look at a few things. First, let’s jump back to the income statement real quick. Now we know that the interest expense falls into this other category. So it’s smart for us to look at operating income, which is right above it. So now the question is, is Apple’s interest expense of about 3.6 billion dollars? Is it too much? Well, given the size of their operating income, even if they doubled their interest expense from 3.6 billion to 7.2 billion, well, they still have tons of operating income room to cover that. Now, what if operating income, on the other hand, was just 6, 6 billion dollars? We’ll compare that to their current level of 3.6 billion interest expense. And they don’t have a lot of wiggle room there. And to me, that would be very dangerous for a company that would be borderline too much debt, economic recession, a pullback in revenue and therefore a pullback in operating profit. Well, that would expose this company to default risk if they only had $6 billion dollars while simultaneously having an interest expense of 3.6. Now, we should also check our cash flow statement and just so we’re on the same page. A rough estimate of free cash flow is calculated by taking the cash flow from operations and subtracting capital expenditures. That’s what this line item is. They don’t always call the capital expenditures, but that’s what it is. Now, if we do that math real quick, we can see that they have free cash flow of about fifty nine billion dollars. And once again, when we compare this to the interest expense of 3.6 billion, they have more than enough room to cover the interest expense. But another check that makes a lot of sense to do is jumping back to the balance sheet. And I actually like to do this one first. I oftentimes like to start with the balance sheet. And there’s two main things that we’re looking at. First, under current liabilities, well, we know that the term section of our current liabilities don’t forget current liabilities or liabilities owed over the next twelve months. We can see it’s about 10 billion dollars, but we know that their interest expense is about 3.6 billion right there. That would tell me that at least some of their bonds are going to mature over the next twelve months. That’s why that numbers so much higher than the interest expense. So the first thing we can do is do they have enough cash to cover that right now if they needed to? And clearly, when we look at these two line items, whether they’ve got more than enough cash to cover it now, if this was a bit closer. Another thing we could check is we could check the free cash flow numbers that we get, that we check that we calculated a moment ago. Does free cash flow, will that cover the total amount to the term debt due in the next twelve months? If it did, maybe they don’t need the cash right now. Maybe they use the cash for an acquisition or something. Now, another thing to consider is oftentimes a company will simply issue a new bond and pay off the old bond. So really just kick the can down the road. But let’s imagine that the first bond was issued five years ago, 10 years ago, 10 years ago, maybe interest rates were 6 percent. Maybe they’re maybe they’re 7 percent today. They might issue that very same bond, same amount. But this time it’s a 3 percent or 4 percent. Well, if that would happen, that the company would end up with a lower interest expense on an annual basis. What does that mean? Lower interest expense? Higher profits on the income statement? Higher profits on the income statement leads to higher free cash flow because that would mean higher cash flow from operations. Hired free cash flow makes everything look better. And this is one of the reasons that many people believe this is just another contributing factor, that when lower interest rates happen, will companies tend to do better? So is does when does a company have too much debt? Well, if they keep dropping interest rates, you can really just keep kicking the can down the road. Now, I do think it’s important that a company not overload on debt because then it becomes very, very difficult for them to manage once interest rates tick the other way. But we can see that happening. We can we know we can figure out on their income statement, not on their consumer and their annual report. They usually tell you how much debt is due soon. If interest rates roll up, we’ll know that this is beginning to be a problem. So I think these are good things to pay attention to a good things for us to watch for. Now, I don’t want to completely disregard all the other line items on the balance sheet because I think that it’s important to look through each of them and see if any unusual things jump out at us. Now, if you don’t know if you want a better understanding of how to read many of the different line items of a balance sheet actually didn’t video where I walked through analyzing a balance sheet. If you’re curious, there’s a link right here in this link in the description below. And I want to thank you so much for stick with me all the way. End of the video. I hope you found this interesting. Thanks so much. I’ll see in the next video.

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