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Something I have never seen a good answer to or explanation of: what is an "appropriate" debt or leverage ratio for a healthy company? Obviously, a private com

Something I have never seen a good answer to or explanation of: what is an "appropriate" debt or leverage ratio for a healthy company? Obviously, a private company with hundreds of millions in stable recurring revenue shouldn't operate debt-free -- debt can be a useful tool, even if only as a rainy-day tool for situations such as the recent pandemic. In other words, corporate debt -- and especially low-interest and covenant-free debt that is secured using recurring revenue -- seems like a capital allocation (corporate finance) tool with a set of trade-offs relative to cash and venture investment. But, how much debt is "too much"? I feel like those of us who work in software can sometimes forget that for most industries, venture capital isn't even an option, which means debt can be one of your only growth financing sources of capital -- and even for those in software, some companies are not venture-fundable but might still be debt-fundable. It's clear that the PE firms that load up billion dollar companies with billions in debt are just playing a speculative finance and asset strip-mining game. But, it would be a shame if we invested all of this time, money, and regulation into a robust "financial capital banking sector", and we can't even rely on it for capital that businesses can use to create jobs, service customers, and smooth the rough patches in the economy.

ihodes 6y ago
There's a fair amount of thought behind what the ideal debt ratio should be for a company, but basically the goal is to minimize the cost of capital while maximizing market value.^[1] [1]: https://www.investopedia.com/terms/o/optimal-capital-structure.asp https://www.investopedia.com/terms/o/optimal-capital-structu...
- pixelmonkey 6y ago
  Thank you for this. I did not know the term "Optimal Capital Structure" but it seems like a good jumping-off point for researching the topic.
ciconia 6y ago
> Obviously, a private company with hundreds of millions in stable recurring revenue shouldn't operate debt-free -- debt can be a useful tool, even if only as a rainy-day tool for situations such as the recent pandemic. Why obviously? Seems to me when a crisis hits the last thing you want to have is debt you need to pay back. For example, should Apple, with their huge mountain of cash, have debt? Do they need debt? I guess one can also ask the same about countries. Do they really have to maintain some level of debt in order to have a healthy economy? Why not just have a big bunch of cash put aside for a rainy day? How is this "obvious"?
- pixelmonkey 6y ago
  I think we are conflating "available credit" and "utilized credit". (Or, rather, I didn't clarify that myself.) Available credit is something like, "Company X has $100M in annual revenue and a $5M line of credit, which is not presently utilized." Arguably, such a company is better positioned than the same company X without the $5M credit facility. The cost of the annual fee to maintain the credit facility will be miniscule compared to the security provided by having $5M instantly available in a rainy day scenario. This is the way by which I mean some corporate debt (specifically: available revolving credit) is "obviously" a good idea. You're right that term loans involve more trade-offs: interest, maturity, etc. But those are still trade-offs, not always downsides. Assuming even a modest annual-interest-rate-beating growth rate in the business with a high probability that such growth materializes, the debt can make the business easier to manage and actually increase the probability of sustainable growth. That's the other way in which I believe that debt can be an obvious benefit. But obviously if you take too large a term loan, it can be disastrous, thus my question about debt ratios. For example, for company X above, it's obvious to me that a $100M term loan would probably be dangerous. But, a $10M term loan vs $5M? Not sure. That's why I am curious about ratios.
- pixelmonkey 6y ago
  Also, re: your question about Apple: > For example, should Apple, with their huge mountain of cash, have debt? Do they need debt? Obviously not. Debt is for companies that have already utilized most of their cash, right? Or have future cash flows that they want to access now before the cash actually materializes. Apple, by contrast, should probably become an investor or lender, since it doesn't know what else to do with its excess cash. It certainly serves no purpose being hoarded on their balance sheet.
  - zxcmx 6y ago
    You can create debt in jurisdiction A collateralised with assets (even cash!) in jurisdiction B... potentially without any tax implications. I expect Apple can borrow money basically for free, so there's probably a bunch of financial-engineering type reasons that debt would be useful to them.
- 6y ago
formercoder 6y ago
Think about a company as an entity that invests in projects with the goal of maximizing the time-adjusted return. The company must fund those projects with either debt or equity, and each funding source has a cost. The optimal debt load is one such that the projects undertaken by the company are funded at the lowest cost.
- pixelmonkey 6y ago
  This is a nice theoretical answer, but I am looking for something a little more practical. Also, assume that a company has already acquired all its "expensive capital" via venture markets and sale of private shares. Given the current metrics of the business, how should it decide how much "cheap capital" to acquire via the debt markets?
  - formercoder 6y ago
    It’s perhaps a high level answer but it’s not theoretical, if you are interested in diving deep I would highly recommend Professor Damodaran’s corporate finance course, he is the gold standard and it’s available for free on YouTube. Without repeating the entire course I’ll try and expand. The critical business metric is free cash flow, all operational data leads to that. We can project the firms free cash flows out over a period of years. Now the question is: how much should we spend to get this stream of cash? It’s not simply less than the sum of the cash flows, because the ones that come later are worth less than the ones that come sooner. To account for this, we “discount” those cash flows at a specific rate, the weighted average cost of capital. This number is where we bring in the mix of debt and equity in the firm and contains the cost of equity financing and the cost of debt financing, which mostly has to do with what interest rate the firm can borrow at. There is an optimal quantity of debt that minimizes this discount factor, thus maximizing the value of the future cash flows, it’s convex. If we can spend less than those summed discounted cash flows, funded with that optimal mix of debt and equity, we are NPV positive. This means we are generating real economic profits with our business activities.
    - pixelmonkey 6y ago
ericmcer 6y ago
Debt used to create value or accelerate value creating processes is good debt. Debt used for stock buybacks, paying off interest on existing debts, executive bonuses, etc. is bad debt. It is pretty straightforward, we just seem to have lost our connection between the stock market valuation and the actual value of companies. We were content watching companies increase in value when they were actually stagnating and drowning in debt.

ihodes 6y ago

There's a fair amount of thought behind what the ideal debt ratio should be for a company, but basically the goal is to minimize the cost of capital while maximizing market value.^[1] [1]: https://www.investopedia.com/terms/o/optimal-capital-structure.asp https://www.investopedia.com/terms/o/optimal-capital-structu...

pixelmonkey 6y ago
Thank you for this. I did not know the term "Optimal Capital Structure" but it seems like a good jumping-off point for researching the topic.

ciconia 6y ago

> Obviously, a private company with hundreds of millions in stable recurring revenue shouldn't operate debt-free -- debt can be a useful tool, even if only as a rainy-day tool for situations such as the recent pandemic. Why obviously? Seems to me when a crisis hits the last thing you want to have is debt you need to pay back. For example, should Apple, with their huge mountain of cash, have debt? Do they need debt? I guess one can also ask the same about countries. Do they really have to maintain some level of debt in order to have a healthy economy? Why not just have a big bunch of cash put aside for a rainy day? How is this "obvious"?

pixelmonkey 6y ago
I think we are conflating "available credit" and "utilized credit". (Or, rather, I didn't clarify that myself.) Available credit is something like, "Company X has $100M in annual revenue and a $5M line of credit, which is not presently utilized." Arguably, such a company is better positioned than the same company X without the $5M credit facility. The cost of the annual fee to maintain the credit facility will be miniscule compared to the security provided by having $5M instantly available in a rainy day scenario. This is the way by which I mean some corporate debt (specifically: available revolving credit) is "obviously" a good idea. You're right that term loans involve more trade-offs: interest, maturity, etc. But those are still trade-offs, not always downsides. Assuming even a modest annual-interest-rate-beating growth rate in the business with a high probability that such growth materializes, the debt can make the business easier to manage and actually increase the probability of sustainable growth. That's the other way in which I believe that debt can be an obvious benefit. But obviously if you take too large a term loan, it can be disastrous, thus my question about debt ratios. For example, for company X above, it's obvious to me that a $100M term loan would probably be dangerous. But, a $10M term loan vs $5M? Not sure. That's why I am curious about ratios.
pixelmonkey 6y ago
Also, re: your question about Apple: > For example, should Apple, with their huge mountain of cash, have debt? Do they need debt? Obviously not. Debt is for companies that have already utilized most of their cash, right? Or have future cash flows that they want to access now before the cash actually materializes. Apple, by contrast, should probably become an investor or lender, since it doesn't know what else to do with its excess cash. It certainly serves no purpose being hoarded on their balance sheet.
- zxcmx 6y ago
  You can create debt in jurisdiction A collateralised with assets (even cash!) in jurisdiction B... potentially without any tax implications. I expect Apple can borrow money basically for free, so there's probably a bunch of financial-engineering type reasons that debt would be useful to them.
6y ago

formercoder 6y ago

Think about a company as an entity that invests in projects with the goal of maximizing the time-adjusted return. The company must fund those projects with either debt or equity, and each funding source has a cost. The optimal debt load is one such that the projects undertaken by the company are funded at the lowest cost.

pixelmonkey 6y ago
This is a nice theoretical answer, but I am looking for something a little more practical. Also, assume that a company has already acquired all its "expensive capital" via venture markets and sale of private shares. Given the current metrics of the business, how should it decide how much "cheap capital" to acquire via the debt markets?
- formercoder 6y ago
  It’s perhaps a high level answer but it’s not theoretical, if you are interested in diving deep I would highly recommend Professor Damodaran’s corporate finance course, he is the gold standard and it’s available for free on YouTube. Without repeating the entire course I’ll try and expand. The critical business metric is free cash flow, all operational data leads to that. We can project the firms free cash flows out over a period of years. Now the question is: how much should we spend to get this stream of cash? It’s not simply less than the sum of the cash flows, because the ones that come later are worth less than the ones that come sooner. To account for this, we “discount” those cash flows at a specific rate, the weighted average cost of capital. This number is where we bring in the mix of debt and equity in the firm and contains the cost of equity financing and the cost of debt financing, which mostly has to do with what interest rate the firm can borrow at. There is an optimal quantity of debt that minimizes this discount factor, thus maximizing the value of the future cash flows, it’s convex. If we can spend less than those summed discounted cash flows, funded with that optimal mix of debt and equity, we are NPV positive. This means we are generating real economic profits with our business activities.
  - pixelmonkey 6y ago

ericmcer 6y ago

Debt used to create value or accelerate value creating processes is good debt. Debt used for stock buybacks, paying off interest on existing debts, executive bonuses, etc. is bad debt. It is pretty straightforward, we just seem to have lost our connection between the stock market valuation and the actual value of companies. We were content watching companies increase in value when they were actually stagnating and drowning in debt.