I’ve been thinking about debt and leverage after reading the Warren Buffet (Berkshire Hathaway) shareholder letter.
For individuals debt can be dangerous.
It is easy for consumers to rack up debt in part due to the ceaseless marketing of credit solicitations. This includes everything from credit cards to unnecessary and ill-advised student loan debt. Some consumer debt may be unavoidable but much of it is discretionary.
Self-discipline is advisable. The consumer should never allow debt levels to become so high that it closes off options and opportunities such as changing jobs, getting married, and so on.
On the other hand, if used properly debt can allow individuals to enjoy a higher standard of living, earlier, than what could be experienced otherwise.
In his last shareholder letter, Warren recommends that individual investors avoid using debt to purchase equities. “It is crazy in my view to borrow money on securities,” he tells CNBC. “It’s insane to risk what you have and need for something you don’t really need.” As Warren also earlier said, “Leverage is the only way a smart guy can go broke.”
In other words, he recommends avoiding the use of margin. For the vast majority of individual investors in the stock market. I completely agree. But debt is not such a straightforward thing in other situations.
In business, debt can allow projects to happen that could not have otherwise. And it can “juice” returns by creating excess value.
There are two traditional ways to finance a business – through equity or debt. Hybrid financing vehicles exist that are a combination of equity and debt. Other financing methods are emerging such as Initial Coin Offerings, but debt and equity still remain the primary standbys. Let’s just consider equity and debt to keep things simple here.
Debt for small business owners is often like that for individuals. This is because a small business is sometimes nothing more than an extension of the owner. The commonly required personal guarantees on small business debt is a major example.
When we advise business owners, we usually suggest that the business needs to be separated as much as possible from the owner’s personal situation. That can be hard to do. But is very important for the protection of personal assets and allows for the easy sale of the business to a third party.
The dynamics for larger, more independently structured companies are different. Debt is simply another way to finance business. Debt financing allows the company to invest in new assets that can grow the business before the funds are earned. This is appropriate in an aggressive growth strategy scenario.
Debt is cheaper than equity (generally) in the long run. This is in part because of its tax deductibility. And is even cheaper in a low-interest rate environment.
Debt allows the business owner to better maintain control of the company. The debtor has to make the contractual payments according to terms but that’s all of the obligation. The business owner can run the business however they want without interference.
The cheaper costs and advantages of debt financing does come at a price. Too much debt can stop growth dead in its tracks by soaking up cash flow.
Debt is riskier than equity and defaulting on a loan can have devastating consequences for a business. The company must repay the loan and interest. Not doing so means the lender can initiate repossession on the assets used to collateralize the loan. Lenders are given priority in getting repaid over equity holders in a liquidation.
Decision Makers in both large and small companies should know that interest-bearing debt reduces the value of the company, by the amount of the debt. So before taking on debt, the debtor (whether an individual, small business, or large company) should consider this consequence too.
Make sure the debt is incurred for a good reason. Especially considering that the value of the project/purpose that the debt is financing should be worth more than the debt itself. That is how value is created. And hopefully, the value is created sooner rather than later. There should be enough reliable cash flow available so that the chances of not being able to make the required periodic payments are as small as possible.
Debt has helped our economy grow faster than it could have otherwise if debt were not as common. So on a societal-public policy level, debt can be a good thing. Too much debt, the overuse of debt, can destroy. As demonstrated in 2008.
Here is what Warren Buffett says from the “Life and Debt” section of the 2010 Berkshire Hathaway shareholder letter:
“Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor. When leverage works, it magnifies your gains. Your spouse thinks you’re clever, and your neighbors get envious. But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people.”
“Leverage, of course, can be lethal to businesses as well. Companies with large debts often assume that these obligations can be refinanced as they mature. That assumption is usually valid. Occasionally, though, either because of company-specific problems or a worldwide shortage of credit, maturities must actually be met by payment. For that, only cash will do the job.”
“Borrowers then learn that credit is like oxygen. When either is abundant, its presence goes unnoticed. When either is missing, that’s all that is noticed. Even a short absence of credit can bring a company to its knees. In September 2008, in fact, its overnight disappearance in many sectors of the economy came dangerously close to bringing our entire country to its knees.”
