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Principles of Finance: Unit 4, Debt Drivers 4 Views


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What are debt drivers, and do they charge less than Uber? Uh, no. We're talking stuff like pre-tax cash profits and assets.

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00:00

Principles of finance Ah la shmoop det drivers All right

00:07

dad Well it's Never a good thing if you're still

00:09

talking about it on your credit card post black friday

00:12

But you know it happens to all of us when

00:15

it comes to business Debt is complicated So it takes

00:18

some time to look at some of the most important

00:19

drivers of debt No Besides the release of the new

00:23

nintendo console that it's us personally every year All right

00:26

so our dead driver numero uno is pretax cash profits

00:32

So that's cash flow before tax it's just you know

00:36

our profits before it's pay the may and the team

00:38

and the government All right Well this number is a

00:40

proxy for ebitda or earnings before interest taxes depreciation amortization

00:45

called kind of cash flow Er adjusted cash flow here

00:48

So remember how interest is deductible from taxes Yeah very

00:53

important concept here because relates directly to the net cost

00:57

of renting money when we borrow it Okay That's a

01:00

big driver of dead and that's The reason we look

01:03

att pretax cash profits rather than earnings or really anything

01:08

else when we think about debt levels because if we

01:10

look at it pretax We get a better sense for

01:13

what our net cost is going to because that interest

01:15

our rent's gonna be deductible from our taxes Alright we're

01:18

also highly sensitive too cash earning since banks don't usually

01:22

take as interest payment a few percent depreciation of a

01:26

tractor smelting plant theyjust want cash right that rent new

01:29

money they just want cash Okay so when we think

01:32

about debt levels the first place we go to figure

01:34

things out is the cash flow statement Remember whose king

01:38

Yeah cash so cash profits then get used to pay

01:42

interest on a given loan Let's say we're hungry to

01:48

buy back one of our own stock because we're really

01:51

bullish on our prospects for the next four years of

01:54

business And we think the market is a bunch of

01:56

morons to be selling our stock at just ten times

01:59

earnings Right now we have no debt and no cash

02:01

at the moment In this theoretical example of a hundred

02:04

million dollars of pre tax cash earnings xing out depreciation

02:07

and amortization our banker has told us that if we

02:10

borrow less than a red line amount of debt meaning

02:13

an enormous amount so that it's risky well we'll pay

02:15

six percent of interest Redline is code for too much

02:19

borrow less basically that's what red line tells you so

02:22

one big ratio we have to worry about is times

02:25

interests covered and that's not from the magazine on the

02:28

multiple of interest being covered So let's say we borrow

02:32

three times ebitda or three hundred million dollars at six

02:35

percent interest Well that's eighteen million dollars a year in

02:39

interest costs payable in cash all happily deductible So since

02:44

we pay thirty percent corporate income tax well that six

02:48

percent feels on an after tax basis like it's four

02:52

point two percent You see there's all our math their

02:54

fancy All right you have a hundred million dollars in

02:56

pretax cash earnings this year at eighteen million dollars of

03:00

interest We have one hundred divided by eighteen equals five

03:04

point five Five x or five five times interest coverage

03:08

Probably awesome and very easy to cover with very little

03:11

risk that will go bankrupt with just three times dead

03:14

Teo even dot leverage But there are ways in which

03:17

this can get dicey What if we had tto have

03:20

ten billion dollars in revenue I earned that hundred million

03:23

dollars like we're a really low margin business Only one

03:27

percent margin like newspaper poll Well if this is good

03:31

times and our margins get cut to half a percent

03:34

in bad times or if revenues declined five percent margins

03:38

turned highly negative Well then we'd be sunk Yeah key

03:41

concept You can't look att any of these numbers in

03:44

a vacuum They always have to be placed in context

03:46

of the business being run and low margin businesses When

03:50

times get bad off lose a lot of money so

03:53

they are not appropriate usually For dead same deal with

03:56

highly volatile companies Okay so let's think about us stable

04:00

reliable company wealthy odds that people stopped next year drinking

04:04

coca cola or watching tv or downloading You know art

04:09

films from the internet are really low same deal with

04:13

people not gassing up their cars or needing health care

04:16

or electricity Very steady reliable high margin generally speaking industries

04:22

And not surprisingly those industries tend to carry a lot

04:25

of debt Well the opposite is true for the highly

04:28

cyclical industries like the manufacture of semiconductors automobiles washing machines

04:34

and vanity surgery If there was a publicly traded thing

04:37

well generally speaking debt teo even ratios of three or

04:40

less are relatively safe And carrie relatively low interest cost

04:45

to rent that money because investors feel pretty sure the

04:47

money will get paid back along with principal on time

04:50

as promised ratios over seven acts are generally kissing bankruptcy

04:55

unless there is some very special situation involved All right

04:58

moving on Our next major debt driver is assets that

05:02

his company assets the stuff the company owns like land

05:05

building patents that kind of stuff So in the first

05:08

example we focus on the ability of the company to

05:09

pay the interest on the loan in cash Paying down

05:12

principle is a good thing as well But many companies

05:15

with steady profits tended Just leave principle on the books

05:18

and used the quote excess unquote cash to buy back

05:21

stock or by competitors or do other smart financial things

05:24

with the dough But if things go really awry and

05:27

the company had toe liquidate itself or part of itself

05:31

i'ii selling off parts and then get those who loaned

05:34

it the money their principal back plus interest Well then

05:37

the amount of assets the company has is a big

05:40

deal right They can sell off a jet engine division

05:43

get a lot of cash for it and then pay

05:45

back debt holders So the rest of the companies well

05:48

balance sheet to do just fine It's also a big

05:51

deal Is that how those assets are pounded for when

05:54

they get sold off that fish tank the secretary bought

05:57

for twenty five grand in the lobby Was the company

05:59

carrying it at book value A twenty five thousand dollars

06:03

Did it depreciate the tank Five thousand dollars a year

06:06

each year So now the net book value is five

06:08

grand after four years Or does the company really think

06:11

that it would net twenty five thousand dollars in revenue

06:14

to the company for that fish tank If the secretary

06:17

put it on ebay and sold it you know even

06:20

if they clean off the algae and get rid of

06:21

that smell Yeah it's probably worth almost nothing anyway Should

06:25

an asset liquidation be needed the quote debt ratio or

06:29

total debt over total asset is a big ratio we

06:33

really care about Simply put these air both current and

06:37

long term debts and current and long term assets Okay

06:40

so in a liquidation event everything is on sale and

06:44

how easily or not Easily it is to sell off

06:47

a little asset here And there is a big deal

06:49

so it's worth looking at alright but an asset sell

06:52

off his only one half of the light that the

06:54

debt ratio shines on things The other half revolves around

06:58

how the company is capitalized Meaning Did the company rely

07:01

on debt or on equity Tofu fund its operations and

07:05

infrastructure build What does that mean Well in this case

07:08

you have to look at a few things but the

07:09

basic idea is this Does the company have a lot

07:12

of debt relative to shareholder equity In the subtext there

07:16

is the company's operations Were they profitable Did they generate

07:20

cash that the company rich chained and called equity Or

07:24

did they just kind of borrow their way to prosperity

07:27

So how does all that work Well this ratio is

07:30

a loose litmus test for whether or not the company's

07:32

properly capitalized to do things it is supposed to dio

07:35

And generally speaking the more leveraged iii has more debt

07:39

that a company is the more volatile it is in

07:41

good times it does better in bad times It does

07:43

waris versus a company with lower levels of debt on

07:46

the balance sheet And the ratio you'll focus on in

07:48

this zone is the debt ratio Yeah Shockingly named which

07:52

is just total death divided by total assets And wow

07:56

things can go badly when they do go badly Let's

07:59

take a gander at what is life likely to be

08:01

one of the greater bankruptcies in private equity history in

08:04

clear channel communications Well this company used to be one

08:08

of the dominant premiere radio Broadcasters in the world for

08:12

the first thing of interest here is just the story

08:14

company used to borrow tons and tons and tons of

08:17

debt They bought competitive radio stations and raised rates and

08:21

everything was great when everyone was still listening to the

08:23

radio but well then they stop They started talking on

08:27

the cell phone and they started listening to premium x

08:30

m satellite and the value of all those terrestrial radio

08:33

station licenses Well pretty much went to nothing but the

08:36

radio Station's lost listeners and couldn't charge advertisers much money

08:40

for listening in Yeah so that's what happened So yeah

08:44

ratings went down and down and down and down and

08:46

all of a sudden a thirty second drive time spot

08:48

which used to sell for three hundred fifty dollars now

08:51

could barely be given away for two hundred dollars but

08:54

on its own Actually that wouldn't have been the end

08:56

of the world How well in its day radio was

08:58

a spectacularly good business Here's how it worked You'd get

09:02

a sales guy to put on a coat and tie

09:04

and meet with some nice little old ladies in your

09:06

city and tell them all about the country music you

09:09

loved and wanted to play along with the sunday morning

09:11

church service you wanted to broadcast from pastor pete all

09:15

free on your nickel you'd set up the recording thing

09:18

with pastor tape it and broadcast it for free The

09:21

old ladies with kibitz and they'd give you a green

09:23

light to go through the fcc process of receiving a

09:25

license to be one of the seven radio stations in

09:27

their market that served fifty thousand people You'd spend a

09:30

million box putting up an antenna or buying the already

09:33

existing one from the guy who died who's ninety seven

09:36

point three on the dial that you were taking you

09:38

get one form or another of a music player either

09:41

records or seedy ron back then or whatever and he'd

09:44

play music for forty eight minutes and have ads for

09:46

twelve A decent station would have two million dollars in

09:49

expenses and twelve million dollars in revenues in a given

09:52

year in a smaller market ten million dollars of gross

09:55

profit And this was when there were seven competitors in

09:57

a market in the laws change and everyone bought each

10:00

other using a whole lot Of a debt to do

10:01

so and the markets boiled down to well basically the

10:04

old cbs radio which was infinity and clear channel and

10:08

the duopoly raised prices like coke and pepsi The increased

10:11

ads from twelve minutes to twenty minutes and wow they

10:15

coined money for a few years that twelve million dollars

10:17

in revenues became twenty million while expenses like commissions just

10:21

doubled So what went from two to four So twenty

10:24

million moneys for sixteen million here in gross profits so

10:27

always great right Well when the company's bought each other

10:29

they took on tons of dead because they didn't want

10:32

dilution from their equity ownership and they paid prices on

10:35

each other that we're high So a typical station if

10:38

you unit ties the numbers or made him injust a

10:41

bollock art one station they were buying at twenty million

10:44

in revenues to four million really of expenses and a

10:47

hundred million dollars of dead at and percent interest And

10:49

yes debt was more expensive back then that said things

10:52

worked just fine for a while On eighteen million dollars

10:55

of pre tax free cash low the ten million dollars

10:59

a year in interest was just fine to pay even

11:01

if it had only been sixteen and they'd have four

11:02

million of expensive whatever didn't matter they could pay down

11:05

a lot of the dead along the way All right

11:07

well we roll the clock forward Five years and radio

11:10

has begun its decline It's two thousand five or so

11:13

and the twenty million of revenues that was a layup

11:15

is now fourteen on its way to ten and management

11:18

knows that next year it'll be thirteen and then twelve

11:21

and eleven and ten Yeah that's how they're going to

11:23

go But even on fourteen million with a few million

11:25

in expenses the company makes enough to pay its bills

11:27

principles down to ninety million at this point in ten

11:30

percent all that's nine million and interest still plenty of

11:32

cushion And oh by the way with all this interest

11:35

none of these companies had to pay any taxes during

11:37

this era They weren't technically profitable but you get the

11:40

idea Roll a clock forward five more years and not

11:42

only is their cellphone ubiquity but except satellite has taken

11:46

over the world and other internet streaming things while they

11:49

take over management of the car in radio basically dies

11:53

well clear channel survives today it isn't yet bankrupt but

11:56

it's worth watching because vultures hawks and other scavengers are

11:58

hovering over the assets other than the quotes dick unquote

12:02

value or radio broadcast station itself there really no assets

12:05

in radio They don't own the music they just lease

12:08

it There is a notional brand value of k f

12:11

r c you're k f o g or ko emi

12:13

like radio stations popular in silicon valley but if incrementally

12:16

fewer people are listening to them well then what's that

12:18

really worth in an asset sale You know well the

12:22

spectrum on which the radio stations broadcast probably were something

12:25

that's probably an asset maybe something meaningful but it isn't

12:28

owned by the radio broadcaster It is leased to them

12:31

by the government for a small amount of money for

12:33

cycles three to five years long when it then gets

12:35

re evaluated by the government so the station can't sell

12:38

something it doesn't own And why wouldn't the government take

12:41

it back anyway of station isn't using it anyway Ugly

12:44

situation unclear asset sales super smart people loaned them a

12:48

ton of money and super smart people run the company

12:50

but yes caveat emptor bad things happen to good people

12:54

all the time Life as an investor or professional lender

12:57

is not for those with a mindset of wanting a

12:59

safe secure existence The other big debt ratio that gets

13:02

called upon by nervous nellie bond investors is the debt

13:05

to equity ratio which is simply total debt divided by

13:08

total equity iii that shareholders retained equity thing on the

13:12

balance sheet right They're the most pragmatic of the debt

13:15

coverage ratios is thie times interest covered ratio which is

13:19

operating profits divided by interest expense and it's a reflection

13:23

of how easily the company's cash can pay the interest

13:26

expense on its debt Why do you do it before

13:28

tax Well remember here in the beginning we talked about

13:31

this interest is tax deductible So if you had a

13:34

year where your company had a hundred million dollars in

13:36

operating profits and no debt well out of thirty percent

13:39

corporate rate you'd pay thirty million dollars in taxes Next

13:42

year you take out two billion in debt at five

13:44

percent and pay interest on ly while youto two billion

13:47

dollars times five percent or one hundred million bucks in

13:49

interest if you still had operating profits of a hundred

13:52

million dollars youto zero taxes Why we repeat because interest

13:56

costs are tax deductible fully The basic idea is that

14:00

if you have a large multiple of interest costs in

14:03

the form of operating profits you should be in good

14:06

shape to pay the interest on your debt and live

14:08

to fight another day But be careful The same deal

14:11

doesn't apply to your credit card so keep it cool

14:14

pal That mega ultra big screen will just have to 00:14:17.302 --> [endTime] wait for next christmas Oh

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