|How much is too much debt? In its announced acquisition of EMC, Dell will borrow over $40 billion to complete the deal|
(Corporate debt includes an array of funding sources: bank loans, corporate bonds, private-placement notes, structured notes, subordinated debt, convertible debt, etc.)
Debt can be a burden; it be can be hurdle, a conundrum, or the elephant in the room. This month, Dell announced it will acquire EMC, the cloud-computing and data-storage company, in a major deal that will acquire that it assume over $40 billion in new debt to consummate it. Will that debt load eventually haunt the combined companies? Or will it be the spark to promote revenue growth and surging earnings?
If shrewdly deployed, debt can lead to higher stock prices or company valuations. Some companies could be better off if they borrowed more. Other companies have no more room to borrow another dime.
Others use a combination of new debt and new equity to spearhead growth and expansion. Financial institutions, with blessing from regulators, pile on long-term debt to avert the possibility of an occasional "run on the bank."
Debt-to-equity ratios are often analyzed. Cash-flow coverage models are deployed. Analysts sample many capital structures to determine the right debt load. Past experience and history (previous defaults, bankruptcies, and companies that deteriorated in the past, e.g.) and current statistics (probabilities of defaults, e.g.) are useful, as well.
Grappling with "Ebitda"
To determine what might be too much of a burden, a favorite, traditional ratio for analysts is a Debt-to-Ebitda (“E-bit-dah”). Earnings, of course, are an obvious source to manage the burden and pay down debt when it's due. Debt/Ebitda is a useful tool to measure what's too much, but the ratio alone is a flawed approach.
First things first. Let’s agree on what “Ebitda” is, why it is a popular reference to a company’s performance, and why it might lead to a flawed approach.
Credit and equity analysts like to use this common pre-tax earnings line item as a proxy for operating cash flow, a “back-of-the-napkin” estimate of actual cash generated from operations before they derive it more precisely.
Picture two bankers in a discussion of a client’s performance. They want to size up operating cash flow without the benefit of spreadsheets, calculators or detailed financial information. Ebitda is a start.
Ebitda is the first glance at whether operating cash flow is positive, negative or trending one way or the other. It is what it can be—a cash-flow proxy. Analysts, nonetheless, must be mindful it disregards working-capital adjustments, capital expenditures, and a list of other required pay-outs (e.g., lease and tax payments).
Sometimes Ebitda is a fairly close approximation to actual derivations; often, it over-states actual cash flow or disregards how a company may generate cash from non-operating activities (e.g., the sale of an investment or manufacturing facility). (Last year, Pepsico reported Ebitda of about $14 billion. An analyst might compute gross operating cash flow at about $12 billion.)
But all analysis must start from somewhere.
Debt-to-Ebitda as a Debt-Burden Tool
Now Debt-to-Ebitda. This ratio is used frequently to measure debt burden. To assess whether debt is too high or has become a financial challenge, analysts look at an array of debt ratios (Debt/Equity, Debt/Tangible Equity, LT Debt/Equity, Cash/ST Debt, e.g.).
- Ebitda, as mentioned, is still an approximation of cash flows,
- The ratio assumes cash from operations is available only for debt-related payments,
- The ratio disregards interest rates and related fluctuations,
- The ratio neglects that tax obligations are real, required, and must be tended to, and
- The ratio presumes earnings are not necessarily available for dividends, new investments and capital expenditures—an unrealistic scenario for many companies.
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