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Principles of finance Ah la shmoop det drivers All right

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

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talking about it on your credit card post black friday

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But you know it happens to all of us when

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it comes to business Debt is complicated So it takes

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some time to look at some of the most important

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drivers of debt No Besides the release of the new

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

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so our dead driver numero uno is pretax cash profits

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

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

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and the government All right Well this number is a

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proxy for ebitda or earnings before interest taxes depreciation amortization

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called kind of cash flow Er adjusted cash flow here

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So remember how interest is deductible from taxes Yeah very

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important concept here because relates directly to the net cost

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

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

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att pretax cash profits rather than earnings or really anything

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else when we think about debt levels because if we

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look at it pretax We get a better sense for

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what our net cost is going to because that interest

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

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

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take as interest payment a few percent depreciation of a

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tractor smelting plant theyjust want cash right that rent new

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money they just want cash Okay so when we think

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about debt levels the first place we go to figure

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things out is the cash flow statement Remember whose king

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Yeah cash so cash profits then get used to pay

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

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

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bullish on our prospects for the next four years of

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business And we think the market is a bunch of

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morons to be selling our stock at just ten times

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earnings Right now we have no debt and no cash

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at the moment In this theoretical example of a hundred

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million dollars of pre tax cash earnings xing out depreciation

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and amortization our banker has told us that if we

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borrow less than a red line amount of debt meaning

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

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six percent of interest Redline is code for too much

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

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one big ratio we have to worry about is times

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

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

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three times ebitda or three hundred million dollars at six

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

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interest costs payable in cash all happily deductible So since

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we pay thirty percent corporate income tax well that six

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

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

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fancy All right you have a hundred million dollars in

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pretax cash earnings this year at eighteen million dollars of

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interest We have one hundred divided by eighteen equals five

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point five Five x or five five times interest coverage

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Probably awesome and very easy to cover with very little

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risk that will go bankrupt with just three times dead

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Teo even dot leverage But there are ways in which

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this can get dicey What if we had tto have

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ten billion dollars in revenue I earned that hundred million

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

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percent margin like newspaper poll Well if this is good

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times and our margins get cut to half a percent

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in bad times or if revenues declined five percent margins

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

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

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a vacuum They always have to be placed in context

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of the business being run and low margin businesses When

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times get bad off lose a lot of money so

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they are not appropriate usually For dead same deal with

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

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reliable company wealthy odds that people stopped next year drinking

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coca cola or watching tv or downloading You know art

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films from the internet are really low same deal with

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people not gassing up their cars or needing health care

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or electricity Very steady reliable high margin generally speaking industries

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And not surprisingly those industries tend to carry a lot

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of debt Well the opposite is true for the highly

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cyclical industries like the manufacture of semiconductors automobiles washing machines

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and vanity surgery If there was a publicly traded thing

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well generally speaking debt teo even ratios of three or

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less are relatively safe And carrie relatively low interest cost

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to rent that money because investors feel pretty sure the

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money will get paid back along with principal on time

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as promised ratios over seven acts are generally kissing bankruptcy

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unless there is some very special situation involved All right

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moving on Our next major debt driver is assets that

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his company assets the stuff the company owns like land

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building patents that kind of stuff So in the first

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example we focus on the ability of the company to

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pay the interest on the loan in cash Paying down

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principle is a good thing as well But many companies

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with steady profits tended Just leave principle on the books

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and used the quote excess unquote cash to buy back

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stock or by competitors or do other smart financial things

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with the dough But if things go really awry and

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the company had toe liquidate itself or part of itself

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

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it the money their principal back plus interest Well then

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the amount of assets the company has is a big

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deal right They can sell off a jet engine division

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get a lot of cash for it and then pay

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back debt holders So the rest of the companies well

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

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deal Is that how those assets are pounded for when

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they get sold off that fish tank the secretary bought

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for twenty five grand in the lobby Was the company

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carrying it at book value A twenty five thousand dollars

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Did it depreciate the tank Five thousand dollars a year

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each year So now the net book value is five

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grand after four years Or does the company really think

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that it would net twenty five thousand dollars in revenue

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to the company for that fish tank If the secretary

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put it on ebay and sold it you know even

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if they clean off the algae and get rid of

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

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an asset liquidation be needed the quote debt ratio or

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total debt over total asset is a big ratio we

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really care about Simply put these air both current and

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long term debts and current and long term assets Okay

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so in a liquidation event everything is on sale and

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how easily or not Easily it is to sell off

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a little asset here And there is a big deal

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

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off his only one half of the light that the

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debt ratio shines on things The other half revolves around

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how the company is capitalized Meaning Did the company rely

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on debt or on equity Tofu fund its operations and

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infrastructure build What does that mean Well in this case

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you have to look at a few things but the

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basic idea is this Does the company have a lot

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of debt relative to shareholder equity In the subtext there

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

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cash that the company rich chained and called equity Or

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did they just kind of borrow their way to prosperity

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So how does all that work Well this ratio is

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

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properly capitalized to do things it is supposed to dio

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And generally speaking the more leveraged iii has more debt

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that a company is the more volatile it is in

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good times it does better in bad times It does

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waris versus a company with lower levels of debt on

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

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this zone is the debt ratio Yeah Shockingly named which

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is just total death divided by total assets And wow

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

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take a gander at what is life likely to be

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one of the greater bankruptcies in private equity history in

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clear channel communications Well this company used to be one

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of the dominant premiere radio Broadcasters in the world for

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the first thing of interest here is just the story

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company used to borrow tons and tons and tons of

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debt They bought competitive radio stations and raised rates and

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everything was great when everyone was still listening to the

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radio but well then they stop They started talking on

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the cell phone and they started listening to premium x

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m satellite and the value of all those terrestrial radio

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station licenses Well pretty much went to nothing but the

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

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

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ratings went down and down and down and down and

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all of a sudden a thirty second drive time spot

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which used to sell for three hundred fifty dollars now

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could barely be given away for two hundred dollars but

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

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of the world How well in its day radio was

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

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a sales guy to put on a coat and tie

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and meet with some nice little old ladies in your

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city and tell them all about the country music you

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loved and wanted to play along with the sunday morning

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church service you wanted to broadcast from pastor pete all

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

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with pastor tape it and broadcast it for free The

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

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light to go through the fcc process of receiving a

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license to be one of the seven radio stations in

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

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million box putting up an antenna or buying the already

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

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point three on the dial that you were taking you

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get one form or another of a music player either

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

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play music for forty eight minutes and have ads for

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twelve A decent station would have two million dollars in

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expenses and twelve million dollars in revenues in a given

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year in a smaller market ten million dollars of gross

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profit And this was when there were seven competitors in

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a market in the laws change and everyone bought each

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other using a whole lot Of a debt to do

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so and the markets boiled down to well basically the

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old cbs radio which was infinity and clear channel and

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the duopoly raised prices like coke and pepsi The increased

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ads from twelve minutes to twenty minutes and wow they

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coined money for a few years that twelve million dollars

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in revenues became twenty million while expenses like commissions just

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doubled So what went from two to four So twenty

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million moneys for sixteen million here in gross profits so

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

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

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dilution from their equity ownership and they paid prices on

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

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you unit ties the numbers or made him injust a

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bollock art one station they were buying at twenty million

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in revenues to four million really of expenses and a

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hundred million dollars of dead at and percent interest And

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yes debt was more expensive back then that said things

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worked just fine for a while On eighteen million dollars

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of pre tax free cash low the ten million dollars

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a year in interest was just fine to pay even

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

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

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a lot of the dead along the way All right

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well we roll the clock forward Five years and radio

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

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and the twenty million of revenues that was a layup

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is now fourteen on its way to ten and management

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

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

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go But even on fourteen million with a few million

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in expenses the company makes enough to pay its bills

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principles down to ninety million at this point in ten

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

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cushion And oh by the way with all this interest

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none of these companies had to pay any taxes during

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

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idea Roll a clock forward five more years and not

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only is their cellphone ubiquity but except satellite has taken

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over the world and other internet streaming things while they

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take over management of the car in radio basically dies

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

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

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hovering over the assets other than the quotes dick unquote

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value or radio broadcast station itself there really no assets

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

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it There is a notional brand value of k f

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

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like radio stations popular in silicon valley but if incrementally

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

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really worth in an asset sale You know well the

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spectrum on which the radio stations broadcast probably were something

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

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owned by the radio broadcaster It is leased to them

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by the government for a small amount of money for

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cycles three to five years long when it then gets

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

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

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

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situation unclear asset sales super smart people loaned them a

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ton of money and super smart people run the company

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but yes caveat emptor bad things happen to good people

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all the time Life as an investor or professional lender

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is not for those with a mindset of wanting a

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safe secure existence The other big debt ratio that gets

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called upon by nervous nellie bond investors is the debt

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to equity ratio which is simply total debt divided by

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total equity iii that shareholders retained equity thing on the

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

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coverage ratios is thie times interest covered ratio which is

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

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

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expense on its debt Why do you do it before

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tax Well remember here in the beginning we talked about

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this interest is tax deductible So if you had a

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year where your company had a hundred million dollars in

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operating profits and no debt well out of thirty percent

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

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year you take out two billion in debt at five

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percent and pay interest on ly while youto two billion

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dollars times five percent or one hundred million bucks in

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interest if you still had operating profits of a hundred

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million dollars youto zero taxes Why we repeat because interest

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costs are tax deductible fully The basic idea is that

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if you have a large multiple of interest costs in

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the form of operating profits you should be in good

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shape to pay the interest on your debt and live

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to fight another day But be careful The same deal

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

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

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