11 July 2013

How to Define a Good Debt Ratio?

I hate debt, until recently I tried to use margin on my property investment. It means that instead of using 100% cash invest in 1 property, I can now actually utilize 10% cash to invest in maximum 10 properties, provided the bank allows me to borrow up to 90% loan for each property I have. However, it means that I have to pay more for the interest expenses incurred during the borrowing period.

Same goes to a business. Sometime when the business is in the expansion mode, it is more expensive to get shareholder to fund in more cash to leverage on the growing stage (due to dilution of EPS), and hence the management can decide whether to borrow more money from banks to support the operation activities. Of course, there are some procedures in bank to ensure that the business has the credibility to make the payment based on the cash flow it will generate in future. So in short, if you really want pick up a stock that is highly leveraged, make sure you could understand how its business model works and how consistent the operating cash flow is to ensure that there is no problem for the company to pay the debt.

Excluding financial industry which typically involved in high gearing ratio to generate cash flows / net profits, I would think a Total Debt to Equity Ratio of less than 0.5X a safe ratio me. Anyway this is just a rough idea for me, as I have to do more homework to determine whether the debt that the company is having now is a good debt or bad debt. A good debt to my own definition is to bring in more business to the company without issuing more new shares that could dilude the EPS in future and it gives company flexibility to bring down the debt level whenever the economy circle turns to downtrend.

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