Teh Chad

The debt ratio of a business is one of many ratios that we use in valuation.

The total debt of a given business divided by it’s total assets is the debt ratio. For example: if your business has $478,000 in debt and $1,174,000, the debt ratio for your business is about .407/1 or 41%.

A potential investor may see this number as high or low and will factor that into his evaluation of the business. Some investors will not invest in a company that has more debt than assets, or a company with a debt ratio that is higher than 1.0.

For owners, this number is simply one indicator of the company’s financial health.

A simple application for you would be to calculate your personal debt ratio. If you have a similar ratio to the business above, I’d say that you’re doing alright!

Other related posts:
> Good debt versus bad debt
> How businesses deal with marginal costs and profits

Interest is simply what money makes for its owner. Labor earns wages, property earns rent, and money earns interest.

When we think of interest, we often think of mortgages and the FED. Really, interest is everywhere money is. Money is an asset and assets work hard for their owners. Money works harder than any other asset I know of. Money is unrelenting in earning interest.

Do you have a credit card? Do you have a mortgage? Conversely, have you issued a loan? Have you bought ownership in a company?

Nearly everyone in the western world can say yes to the first two questions. Those same people are confused about what the second two questions entail.

They are different sides of the interest rates. Having a balance on a credit card means that you are paying for the privilege of carrying that piece of plastic around. That’s really it. You’re still spending your money, but on top of using your own money, you are incurring an expense for that convenience.

Mortgages are essentially the same. The principal is still the same money. But interest is earned by that principal. The interest is earned over a much larger time frame and it is normally a much larger cost relative to the principal.
This side of the interest keeps us paying. It takes money out of our pockets.

So I have another question for you: What side of interest are you on? Would you like to stay on the side of paying the interest or would you rather be the one that others pay you for those expensive conveniences?

Nobody who is wealthy under their own doing will tell you that it is easy. Lots of work and discipline is involved.

The second side of interest is much different. We start making things work for us. The loans we have to other people pay us. They put money in our pockets that is on top of the original principal. They give us money for those conveniences.

To answer my original question, we stay behind the interest rates because we are consumers and don’t mind paying for conveniences. These derivatives of simple savings accounts have associated costs. These costs have been downplayed to the point where we don’t pay attention anymore. I contend that we need to pay much more attention.

Not only have we become lazy, but we despise work. There’s a word that has been thrown around a lot recently, but I feel it is appropriate here: change. We need to change our focus. We need to work hard to understand costs and how finance works.

A couple of posts you might like:
> Good debt vs bad debt
> Debt explained

The debate on how any debt can be good is as old as currency. I’d like to talk about how debt can be good and how most debt is bad.

The true financial definition of good debt is debt that pays for itself. An example of this is a rental property where the tenants pay for the property loan, the taxes, upkeep, and all other expenses. The owner is paid a small sum after all of the expenses are paid for holding the full liability of the property loan.

Are the past two financial market implosions (housing and credit) making more sense now?

When someone mentions debt, most people think of their mortgage or their credit cards or their car payment. These are bad debts. They don’t pay for themselves. With those images in mind, it’s easy to see why nearly everyone thinks that all debt is bad.

Earlier in this blog, I posted a pretty long piece on the sides of the interest rate. This blog was very focused on getting out from behind the interest rate, or debt, and getting ahead of it, or investing.

The housing implosion was a result of a few things. People had become a bit too aggressive in their real estate investing. Many people were taking a small monthly hit to make sure they covered their expenses. In contrast, they could have been a bit more conservative and made sure that their loans would be covered by the value of the property.

Around this time, property values were going up and not slowly. When people bought property, they were paying a lot versus the true value of the property. This was coupled with the fact that banks were offering loans with relatively small down payments. These down payments are normally designed to offset any variance in prices for the given property. When prices blew up, initial principals, or down payments, should have followed.

As the bubble worked itself bigger, more and more loans were utilized with less protection. More people were vulnerable.

Then a few people lost their jobs as big companies turned out to be corrupt. All of the sudden, people could no longer take that small hit on their income properties since they didn’t have jobs. Their debt was bad. It was about to get worse. The housing market came full swing.

After a while, the banks put properties into foreclosure and sold them off where they could. However, there was a problem. The bank could not sell the property at a price to cover the loan. The borrowers still owed on a loan that was backed by a property that they didn’t own any more.

Property values dropped out of the sky. They reverted back to prices closer to their true value. Some might argue that property values have dropped below their true value. In places like Detroit and Las Vegas, I would certainly agree with that argument.

This, in turn, caused the credit crisis. Banks were seeing loans defaulted constantly. They were no longer making money. They called on the government. And the government can really only pull money out of the taxpayer pockets.

So, how do I find good debt? I don’t want to go broke and then be poor all of my life!

Finding good debt requires understanding of bad debt, ergo my discussion above. Then we must see that good debt pays for itself. I like the real estate example because it is so readily available in our society.

We have found a house that we think tenants will enjoy occupying. We must first make sure that we are not paying too much overall for the property. Then we must put an adequate down payment.

I keep reading about people who just put the minimum down. This is financial stupidity in my opinion. Not only will a solid down payment give a cushion against a downswing in property value, it will increase a property’s cash flow. This is very important as random expenses happen. Stoves fail and water pipes freeze. Properties need solid financing. Once that is done, tenants are happy to live in the property and pay you consistently for that privilege.

As owners and investors, it is important that we protect ourselves against these financial vulnerabilities.