Name: M.Reza Kusuma A.

Rescue Assignment
NIM: 29117450
Class: YP 58B
How Much Debt is Too Much?

Debt isn’t necessarily a bad thing, even though we tend to see it as such. Having some debt
can quite healthy provided we are in control of our finances and are able to pay it back within
a reasonable amount of time.

In fact, running into debt can sometimes be inevitable—especially when we need to

expand our business or implement new strategies that require more funds than we can afford.
Whenever we borrow money from a bank, credit card company, or even a friend or relative,
we take on a debt.

If we can manage it wisely and pay back on time, it will improve our credit history, and
we will be able to purchase and invest in other important things, such as a home, that we
might not have been able to afford. And more importantly, being able to take charge of our
debts and paying back on time will give us rest of mind.

How much debt is too much for our personal financing?

Each of us must decide if we think debt is an acceptable part of our personal money
management plan. Some consumers say, “I am going to pay off all my debt," as if this is the
goal. They proceed with accomplishing this goal, then turn around and create more debt
(recycling debt).

It takes time for us to determine what we consider acceptable debt and a level of debt
in which we are comfortable. Debt can be viewed from an emotional or linear perspective –
or both.

Emotional Tolerance for Debt

There are many kinds of debt; mortgage loans, credit cards, and educational loans.
We may feel differently about different kinds of debt. Try to identify what kind of debt and
how much debt creates stress for us. If debt is causing us stress it could be attached to: the
size of the debt, what it is costing us to have this debt, or the time it is taking to pay it off.

Time frames can relieve stress, like a 15-year mortgage or a 4-year car loan. Credit
cards are usually not limited by time -- putting a time frame on paying them off could decrease
Name: M.Reza Kusuma A. Rescue Assignment
NIM: 29117450
Class: YP 58B
some stress. Often concrete figures decrease stress. For example, somebody may feel
comfortable with a car loan for 50% of the worth of the car, a house loan for 75% the value
of the house and credit card debt that they can pay off in six months. Knowing their tolerance
for debt assists them in focusing a clear intent with their spending.

Acceptable Debt from Linear Perspective

Another way to perceive our capacity for debt is to calculate our Debt to Income Ratio.
Divide our debt by our gross annual income. For example, a person making $20,000 a year
gross income with $10,000 of outstanding debt has a 50% DTI Ratio. If the Ratio is .30 (30%)
or lower, it indicates that he/she has enough gross income to make debt repayments easily
and it implies financial strength. If the debt ratio is 45% or higher, lenders will perceive
him/her as “over extended” and offered higher interest rates when applying for loans. These
formulas determine whether debt is acceptable from a linear perspective for maintaining
financial balance in their life. Once our capacity for debt is determined, we can set goals for
ourselves to match our intent with our spending choices

How much debt is too much for company?

When we invest in a company there are two important things we’re looking for. First, we
don’t want the company to go broke. And the second thing is that we want it to return more
than we invested. Both outcomes are influenced by how much debt a company carries on its
balance sheet.

Debt can boost returns

Companies typically fund their operations by a mix of debt and equity. Business debt
isn’t always a bad thing. Used prudently, it can boost a company’s return on equity (ROE).
That is, the return shareholders receive on their part of the funding equation. That’s because
debt is typically a cheaper form of funding than money supplied by shareholders (equity).

It’s important that management gets the debt/equity mix right, because too much
debt can place a company in jeopardy when business conditions go sour. That is because,
unlike shareholders, lenders demand to be paid in bad times as well as good. So, a company
Name: M.Reza Kusuma A. Rescue Assignment
NIM: 29117450
Class: YP 58B
should own more than it owes. It’s a simplification, but a good starting point. So, we could
take look at a commonly used metric used to measure the debt/equity.

The Debt to Equity Ratio

The debt to equity ratio quantifies the relative proportion of debt and equity used to
fund a company’s operations. A refinement of the ratio uses net debt instead of total debt.
Net debt is calculated by deducting the cash held by the company from its total debt. It’s a
useful adjustment particularly for companies holding significant cash deposits.

Net debt/equity ratio = (Financial Debt – Cash) ÷ Equity

So, as told before that company should “own more than it owes”, the net debt to equity ratio
for the company should below “1”.

Another way to express this relationship is the percentage of total assets which is
funded by debt. For example, if the net debt/equity ratio is 1 then it would be expressed
(using the formula below) as net debt represents 50 percent of total capital.

Gearing Ratio = Net Debt ÷ (Net Debt + Equity) x 100

Analysing the debt to equity ratio

What constitutes an acceptable level of debt may varies from company to company. And its
determination is a mix of analysis and judgment. There are several important factors to
consider that we can look beside of using the analysis before.

1. Volatile Revenue Stream

Lenders demand that interest and principal payments are made on time and in full.
But when a firm has a volatile revenue stream its ability to meet these regular payments is
less certain. The problem is compounded when a business is burdened with high fixed costs
– the costs of simply keeping the doors open even if it’s not doing any business. So, look out
for red flags, for example where a company’s debt materially exceeds that of its industry
peers.
Name: M.Reza Kusuma A. Rescue Assignment
NIM: 29117450
Class: YP 58B
2. Concentration Risk

When a large portion of the company’s business is limited to a few customers then it’s
prudent for it to carry less debt. Loss of an important customer will impact its revenue stream
and jeopardize its capacity to service debt.

3. Debt Structure (debt maturity)

The mix of long and short-term debt employed by a company is important. Long-term assets
should preferably be funded out of equity and long-term borrowings, while working capital
needs are best funded by bank overdraft and short-term borrowings. Watch out for
companies which rely heavily on the use of short-term debt particularly those with a poor
credit rating. These companies are faced with an ever-present need to keep rolling the debt
over. Failure to do so could lead to failure of the business.

Maturities of borrowings should also be well spread. If the bulk of a company’s

borrowings fall due at a time when the availability of funds is limited, such as the recent post
GFC period, then refinancing may prove difficult. With a chronological spread of maturities,
the need to approach the capital markets for a large refinancing in a depressed period is
reduced.

4. Debt Structure (currency of debt)

Check for the currency in which the debt is denominated. A company with overseas assets
and/or revenue will often reduce its currency exposure by maintaining a similar level of debt
in that currency. If this isn’t the case, offshore borrowing is still OK if it’s largely
hedged/swapped back to Australian dollars. If neither is the case, then the company is likely
to be exposed to the risk of currency fluctuations.

5. Look out for loan covenants

A loan covenant is a clause in the lending contract requiring the borrower to refrain
from doing certain things. For example, the borrower might have to maintain the ratio of total
liabilities (borrowings and other liabilities) to total tangible assets at a certain percentage, say
no higher than 60%. It’s very important that companies maintain such ratios. Even if a
company is fully servicing its debt on time, the breach of such a covenant may lead to a
‘technical breach’ of the contract and potential recovery action by the lender. So, look out for
Name: M.Reza Kusuma A. Rescue Assignment
NIM: 29117450
Class: YP 58B
loan covenants, study how onerous they are, and the likelihood of the company breaching
them.

Augment our analysis with other financial ratios

The debt to equity ratio should not be relied upon to the exclusion of other ratios.
There are many other metrics which can be used to judge the appropriateness of a company’s
debt. Another ratio that’s commonly used is the Interest Cover Ratio. It shows how
comfortably a company can meet its interest payments.

Interest Coverage Ratio = EBIT ÷ Interest Expense

Where EBIT is profit from ordinary activities before interest expense and income tax.
The higher this ratio is, the better, but it should be interpreted in a similar fashion to the debt
to equity ratio. What represents an acceptable figure depends on several factors, including
the nature of the company’s business, the volatility of its revenues and the composition of its
debt. However, as a guide, when an interest coverage ratio falls below 2, concern should be
raised.