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While I'm familiar with the idea that healthy companies can be so leveraged for quick profits that they go out of business, I don't understand the mechanism. Is

While I'm familiar with the idea that healthy companies can be so leveraged for quick profits that they go out of business, I don't understand the mechanism. Is the idea that such over-leveraged companies cease to be otherwise healthy before they go out of business? If so, why? Is the management worse while they are over-leveraged? Is it a matter of market conditions worsening? Why would an otherwise healthy company be liquidated if it couldn't service its debt? Wouldn't lenders rather sell the company as a profitable going concern than accept what's left after liquidating it? A reasonable valuation for a genuinely healthy company would be greater than book value. I'm also confused about the practice of backs selling repossessed buy-to-let homes during a crash, evicting tenants in the process. Why sell low, rather than continue to collect the rent?

Retric 10y ago
Profits fluctuate. If a company generates -1 to 10 billion per year and has 2 billion cash on hand and assets worth 5 billion, they can handle several bad years and will tend to be profitable and very stable. If someone then says they can probably make debt payments of 5 billion a year then they might be able to do that for a while, but it will eventually cause them to fail. The important consideration is you have already made back your investment at this point so the owners don't care. In fact if the company fails that suggests you succeeded in extracting more money than it was worth.
- lambertsimnel 10y ago
  I thoroughly agree with your 1st & 3rd paragraphs, but the situation described in your 2nd paragraph sounds like one in which the lenders are irresponsible, whereas the owners of the borrower alone seem to usually be blamed.
  - Retric 10y ago
    The second paragraph was exaggerated for effect. However, companies are not limited to bank loans, so it may be the bond market taking on these risks. Further, there is an information asymmetry with loans so a company may be cyclical in nature yet look really good over the last five+ years.
anarazel 10y ago
> While I'm familiar with the idea that healthy companies can be so leveraged for quick profits that they go out of business, I don't understand the mechanism. Is the idea that such over-leveraged companies cease to be otherwise healthy before they go out of business? If so, why? Is the management worse while they are over-leveraged? Is it a matter of market conditions worsening? While debt servicing you have less liquidity. That liquidity might be required to react to changes in the market / stay competitive. So the long term health of the company is likely going to be impacted some. EDIT: embarrassing typo

Retric 10y ago

Profits fluctuate. If a company generates -1 to 10 billion per year and has 2 billion cash on hand and assets worth 5 billion, they can handle several bad years and will tend to be profitable and very stable. If someone then says they can probably make debt payments of 5 billion a year then they might be able to do that for a while, but it will eventually cause them to fail. The important consideration is you have already made back your investment at this point so the owners don't care. In fact if the company fails that suggests you succeeded in extracting more money than it was worth.

lambertsimnel 10y ago
I thoroughly agree with your 1st & 3rd paragraphs, but the situation described in your 2nd paragraph sounds like one in which the lenders are irresponsible, whereas the owners of the borrower alone seem to usually be blamed.
- Retric 10y ago
  The second paragraph was exaggerated for effect. However, companies are not limited to bank loans, so it may be the bond market taking on these risks. Further, there is an information asymmetry with loans so a company may be cyclical in nature yet look really good over the last five+ years.

anarazel 10y ago

> While I'm familiar with the idea that healthy companies can be so leveraged for quick profits that they go out of business, I don't understand the mechanism. Is the idea that such over-leveraged companies cease to be otherwise healthy before they go out of business? If so, why? Is the management worse while they are over-leveraged? Is it a matter of market conditions worsening? While debt servicing you have less liquidity. That liquidity might be required to react to changes in the market / stay competitive. So the long term health of the company is likely going to be impacted some. EDIT: embarrassing typo