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.