Lesson 7 of 12 · 3 min · Valuation
How much debt is too much?
Borrowing makes good years better and bad years deadly.
Debt is not bad on its own. It lets a business grow faster. But interest has to be paid in good years and bad ones, and lenders do not wait.
The first test: net debt divided by operating profit. Lemon Co owes $6 million and holds $1 million of cash, so $5 million net, against $2.5 million of operating profit. That is 2 times.
In plain words: if all profit went to repaying debt, Lemon Co would be free of it in about two years. Many analysts start to worry somewhere above three.
The second test: how many times profit covers the interest bill. Lemon Co earns $2.5 million and pays $0.5 million of interest. Five times over, comfortable.
Debt matters most for businesses whose profits swing. A steady water utility can carry a lot. A lemonade stand that depends on the weather should carry little.
Quick question
Company A has net debt of 1 times operating profit. Company B has 6 times. A bad year halves both companies’ profits. Which is in trouble?
- A
- B
- Neither
Show the answer
B
With profits halved, B’s debt is suddenly 12 times profit. Lenders get nervous, and the owners of the shares come last.
Keep this one
Debt is fine until the bad year.
Where this comes from
Net debt to operating profit and interest cover are common rough guides. Where the comfort line sits depends on how stable the business is. Lemon Co is invented for teaching.