Click here for the Club Mailbag email address (investingclubmailbag@cnbc.com). Please direct your questions to Jim Kramer and his team of analysts. We cannot provide personal investment advice. We only consider more general questions about the investment process and stocks in your portfolio and related industries. Question of the week: If you’re evaluating several companies in one industry. What is a good metric to compare debt levels? — Gail This is a great question. There are several metrics to consider. You’re right to consider debt levels and how they compare to other companies in the industry, but take it a step further. There is no point in leaving debt unattended. Instead, you need to think about leverage. This means that you need to consider debt in relation to your assets, profits, and cash flows. Think about it this way. For example, if John has his $100,000 debt in his name and Jane has her $1 million debt in her name, who is better off? Now, you might wonder if John only has his 10% of Jane’s debt. But then what if John also tells the bank that he only has $50,000 in cash, while Jane says he has $2 million in cash? John’s debt in relation to the cash on hand? Considering that John has much more “leverage” than Jane, we can now understand the whole picture better. But that’s not all. Income and cash flow must also be considered. It will tell you whether the two of you are prepared to repay the debt, pay the interest rate (as well as the minimum amount required on the credit card), and stay in good standing. Are standing. If Jane retires and takes in her 5% of $2 million, her income will be her $100,000 (let’s forget about her tax implications for a moment). So what if John is still working and his income is her $200,000? Here’s where things get a little harder. We need to think about what’s more important: is it cash in hand or recurring income?Of course, it’s Jane’s sustainability of her 5% return and John’s job security. It depends on Importantly, there are several factors to consider when it comes to personal debt. Companies should think the same way. Here are three metrics you’ll want to consider. Of course, there are many others. But let’s start with the basics. 1. Net Debt to EBITDA This is a very good leverage ratio to know and consider before buying any shares. This ratio involves dividing its net debt (basically total debt minus cash and cash equivalents) by its earnings before interest, tax, depreciation, and amortization (EBITDA) over an annual period. The net debt to EBITDA ratio helps determine the appropriate debt level in relation to a company’s EBITDA generation. Some investors may now take issue with EBITDA. This is because EBITDA takes into account the real cost of depreciation and amortization. However, this equation makes sense because in a worst-case scenario, a company might consider paying off debt before replacing depreciated equipment, for example. In terms of a healthy ratio, the lower the better, as it means the company can cover more of its debt with the funds it receives from its operations. This number can vary by industry, so it’s a good idea to compare the company in question to its peer group and to its own historical standards. However, in general, a ratio of less than 3x is considered desirable. If it is above that, we need further information from management as to why it is so high and what is being done to lower it. A high ratio can be problematic because it increases the risk of default when business is down, as well as potentially increasing borrowing costs. For example, the portfolio holding Procter & Gamble (PG) has a net debt level of approximately $26 billion and is expected to generate annual EBITDA of approximately $21 billion, resulting in a low net debt-to-EBITDA ratio of approximately 1.24x. It has become. This shows that P&G can maintain a streak of dividend increases (67 years in a row so far) without having any trouble paying off its debt. 2. The debt-to-equity ratio compares a company’s level of debt on the sheet with the amount of equity. To calculate this ratio, simply divide total debt by shareholders’ equity (remember, this equals assets minus debt). For example, if a company has $3 million worth of assets and $1 million worth of debt, shareholders’ equity is $2 million ($3 million – $1 million) and debt-to-equity is 0.5x ($1 million / 2 million dollars). This is an important ratio that helps management determine whether they have an appropriate capital structure in place. Are you using enough debt to maximize operating leverage? Or is there so much debt that it becomes difficult to repay and exposes the company (and shareholders) to the risk of default? Debt-to-equity ratios should be considered relative to peers and take into account the company’s position within the business cycle. However, as a rule of thumb, any ratio greater than 2x should be closely scrutinized. A ratio of more than 4x is a red flag and requires a clear understanding of how management plans to clean up its balance sheet or reconsider acquiring exposure. In the case of Honeywell (HON), the club’s name, the total debt is about $20 billion, the shareholders’ equity is about $17 billion, and the ratio is healthy at about 1.18 times, so there is little need to worry about its financial health. 3. Debt Service Coverage Ratio Since we mentioned earlier the importance of debt service ability, let’s consider a ratio that provides insight into this: the debt service coverage ratio. There are several ways to think about this ratio, but the highest level is to understand a company’s ability to repay its debt. To do this, we use a metric such as operating profit and compare it to the company’s debt service requirements, i.e. the amount of all principal and interest payments due over the next year. This is similar to the net debt to EBITDA ratio, but instead of all financial debt, it’s current debt (think short-term debt, the portion of long-term debt due within a year, and the interest payments associated with the debt) are only considered. . Free cash flow is probably the most conservative metric. After all, if you don’t have cash in the bank, you won’t be able to pay off your debts with borrowings or accounting proceeds. As with most ratios, full-year numbers must be used for this analysis. The higher the number, the easier it is to manage your debt. For example, if a company has free cash flow of $3 million and total debt on its balance sheet of $6 million, its debt service coverage ratio is 0.5x ($3 million / $6 million), which means that free cash flow in one year You will be able to repay it. half of the company’s debt. For example, the club name Eli Lilly (LLY) has approximately $2.25 billion in debt to repay within the next 12 months. But it’s on track to generate more than $5 billion in free cash flow this year alone. There is little reason to think Lilly will have a problem paying off his debts, as his total debt is around $20 billion and he has less than $650 million to $800 million due in the next four years. there is no. (See here for a complete list of Jim Cramer Charitable Trust stocks.) As a subscriber to Jim Cramer’s CNBC Investment Club, you will receive trade alerts before Jim makes a trade. After Jim sends a trade alert, he waits 45 minutes before buying or selling stocks in a charitable trust’s portfolio. 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Click here for the Club Mailbag email address (investingclubmailbag@cnbc.com). Please direct your questions to Jim Kramer and his team of analysts. We cannot provide personal investment advice. We only consider more general questions about the investment process and stocks in your portfolio and related industries.
Question of the week: If you’re evaluating several companies in one industry.What is a good metric to compare debt levels? – Gail