Evaluating Long-Term Debt of a Business*

The debt-to-equity ratio tends to be a poor measure in evaluating the financial strength of a business. The reason for this is that the equity in any business acts as a piece of “security” or “collateral” for the bank loaning the funds, and that is, unfortunately, about all it ever amounts to.

In other words, the equity of a business is not really what a bank is after when granting a loan. It only acts as something for the bank to fall back on in case the company defaults on the loan. What banks are really after is the ability of the company of being able to make the interest payments on the loan well into the future. This ability on the part of the company is directly dependant on its ability to generate positive cash flow and high earnings.

Buffett and Lynch have also found that the assets of a business which help it secure the bank loan are usually so unique to the enterprise that, in truth, they tend to be worthless to anyone else, even thought they may well be carried on the books at considerable value.

The wealth of a company is in its ability to earn a profit, not what it could sell its assets for. Companies that have superior business economics typically have long-term debt burdens of fewer than five times current net earnings. And of this debt it is preferable that it not be bank debt, but rather funded debt.

*Mary Buffett, "Buffettology"