VALUE INVESTING
Debt Is Evil

By Stephen Bland (TMFPyad)
March 26, 2004

How much debt should a company carry? Ideally, none. Well, no net debt anyway. That is, if there is any debt it should be exceeded by cash to give a net cash position. That is my view from a value viewpoint. Only a small minority of shares will fall into this category. The reason is that debt creates risk, when compared to equity finance, because interest has to be paid on time and the debt itself has to be repaid on time. A double risk factor in fact. The value investor seeks to minimise risk, so the less debt the better. No debt equals no debt risk.

However, I am concerned here with theoretical desirability of debt versus equity in the financing of companies. My view is that the optimal capital structure is debt nil, equity 100%. Most companies will never reach that situation, but I am talking of corporate nirvana here, that to which every company should aspire but in practice few will achieve.

You can sometimes read theoretical justifications for debt, often I believe from people who have never been in business, on the grounds that it is somehow inherently desirable when compared with the other source of company finance – equity. Sometimes you can hear the same thinking from those that are in business but only in a corporate sense, in that they might be involved in managing a very large company and not their own proprietorial concern.

What justifications are produced in favour of debt? Tax is one common point. The more beneficial tax treatment of the cost of debt, i.e. interest, when compared with the cost of equity, i.e. dividends, because interest is allowable for corporation tax whilst dividends are not. All true, though the relative costs depend also on the levels of interest rates and of dividends. But since when has tax-led inducement been a sensible way to go about business? Commercial sense must come first. If something makes commercial sense plus there's a tax benefit in it, then fine.

Gearing is another point to consider. Fixed interest payable will produce disproportionately greater rises in post-interest profits than the pre-interest figure. And similarly on the capital side, fixed gearing will produce disproportionately larger increases in the value of a growing investment purchased by debt, net of the debt on it.

The benefits of gearing as above are trotted out often. Much less often discussed is the downside, which works in exactly the same way but opposite. If the pre-interest profits or the value of your investment falls, then there will be a disproportionately large effect on the profits or value after deducting the interest or any outstanding loan. There will come a point where if the profits fall enough, the post-interest figure will turn to loss or if the investment falls in value sufficiently, its worth after deducting debt will be zero or negative. A considerable risk.

Gearing wins only if you are winning. Some will and consequently the debt will have been seen to have been justified. Some won't and will be criticised in consequence for taking on debt rashly. Who will win or who won't depends on the business acumen of the directors of the company. Some of the largest companies in the country are guilty of losing in this regard. BT Group (LSE: BT.A) for example took on astronomic debt a few years ago for new mobile telecom licensing which damn near destroyed the company. Since then it has desperately been selling off assets in order to pay off crippling debts. If it would have been possible to raise the capital for this through an equity issue, the effects would have been far less damaging.

I know that companies needing money can't always raise new equity. It is a complicated process. So debt serves a purpose. But my point is that businesses should take on debt only if they are forced to by circumstances, not because there is anything desirable about it. I don't like the academic justifications for debt. Debt is instinctively a bad thing. Think of yourself. Do you enjoy being debt? A few financial pervs might do, but most people feel happier when their mortgage or credit cards are paid off. That is the common instinct and it is a sound one. The same should apply to business and I've been there. The aim should be to minimise or eliminate debt if possible.

And what in my view suits companies - no debt - suits value investors too. Other things being similar, we would all prefer a share with net cash to one with net debt because it is lower risk.