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Chapter 6

Deciphering Debt: A Crucial Aspect of Business Health

Business debt is an essential topic that mirrors personal financial decisions. In this exploration, we'll delve into the dynamics of debt within businesses, understanding why they borrow, how much is reasonable, and how to evaluate it. Just as we make decisions about loans for cars and houses, businesses also borrow to achieve their goals. Let's uncover the significance of debt, its impact on a business's financial stability, and how to navigate this complex terrain.

Drawing Parallels: Debt in Business and Personal Life

Businesses and families both resort to borrowing when they need something urgently, and waiting isn't an option. For instance, you might take a loan to buy a house instead of wasting money on rent. Similarly, a business like Whole Foods might borrow to construct a new store. Borrowing itself is not an issue—it's the extent of borrowing that matters. When a business accumulates too much debt relative to its income, it enters risky territory where even covering loan payments becomes a challenge.

The Debt Dilemma: Borrowing Beyond Means

Imagine a scenario where you've taken out loans for a house or car based on anticipated future income, and suddenly you lose your job. This struggle to repay loans can lead to bankruptcy, impacting your financial stability. Similarly, businesses can find themselves in dire straits when they borrow heavily and encounter economic downturns or reduced consumer spending.

Unpredictable Future: Debt's Impact on Businesses

A business with excessive debt relative to its income faces an uncertain financial future. Economic fluctuations can swiftly turn an aspiring business into a cash-strapped entity struggling to meet loan obligations. Just as families face challenges when breadwinners lose their jobs, businesses can face financial turmoil due to market shifts. This unpredictability goes against the grain of Rule #1 investors, who seek businesses with stable and predictable earnings.

Debt Evaluation: Striking the Right Balance

Rule #1 investors thrive on certainty, which is why they're wary of businesses with high debt burdens. While the ideal debt amount is zero, borrowing for valid reasons is acceptable. The key is to ensure that the business can pay off its debt promptly. If a business can eliminate its debt within one year of free cash flow, it's a manageable situation. The maximum acceptable payoff time is three years.

A Practical Approach: Evaluating Debt

To determine whether a business's debt is reasonable, calculate its ability to pay off the debt within three years by dividing Total Long Term Debt by current Operating Cash Flow. Focus on long-term debt, as it provides a clearer picture of a company's financial health. This information can usually be found on the Balance Sheet under "Long Term Debt." Remember, percentages alone might not offer the full picture; it's essential to have actual dollar values for accurate evaluation.

The Path Forward: Mastering Debt Assessment

Understanding and evaluating debt is a critical skill for investors. By grasping the right level of borrowing and its implications, you can confidently navigate the business landscape. Keep in mind the Rule on Debt—paying off debt within three years—and use this principle to assess potential investments. As you embark on your investment journey, remember that debt is a significant piece of the puzzle, and your awareness of its impact can guide you toward informed and prudent decisions.