Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Loans====== A loan is a fundamental form of [[Debt]]. At its core, it's a simple agreement: a person or institution (the [[Lender]]) gives money to another (the borrower), who agrees to pay back the original amount, known as the [[Principal]], plus an extra fee called [[Interest]], over a set period. Think of it as renting money. The interest is the rental fee you pay for using someone else's capital. Loans can be **secured**, meaning the borrower pledges an [[Asset]] (like a house or factory) as [[Collateral]] that the lender can seize if the loan isn't repaid. Or, they can be **unsecured**, relying solely on the borrower's creditworthiness. For a business, a loan is a powerful but double-edged sword. It can fuel growth, fund acquisitions, or smooth out cash flow. However, it also introduces risk and a fixed cost (the interest payments) that must be met, rain or shine. Understanding a company's relationship with its loans is a cornerstone of smart investing. ===== A Company's Double-Edged Sword ===== Why do companies borrow money? It's all about [[Leverage]] – using borrowed capital to, //hopefully//, generate higher returns than the cost of the debt. A company's attitude towards loans reveals a lot about its strategy and management's confidence in the future. ==== The Allure of Borrowing ==== Companies often turn to loans for a few key reasons, which can be signs of health and ambition: * **Growth Fuel:** To build new factories, enter new markets, or fund research and development for the next big product. * **Strategic Acquisitions:** To buy other companies and grow by acquisition, ideally integrating them to create more value. * **Working Capital:** To manage day-to-day operations, like paying suppliers before customers pay them, which is a normal part of business. The dream scenario for a shareholder is when a company borrows money at 5% interest to invest in a project that generates a 15% [[Return on Invested Capital (ROIC)]]. That 10% spread is a beautiful thing, magnifying shareholder wealth without them having to put in another dime. ==== The Dangers of Debt ==== However, leverage can cut both ways. If that same project only returns 2%, the company is losing money on the borrowed funds. Debt creates a **fixed obligation**. Interest payments must be made regardless of how the business is performing. Too much debt can starve a company of cash needed for other opportunities or, in a downturn, lead to financial distress and even [[Bankruptcy]]. It's the financial equivalent of driving a car faster – you might get to your destination quicker, but any mistake can be catastrophic. ===== How Value Investors Scrutinize Loans ===== As a value investor, your job isn't to avoid companies with debt, but to understand it. You need to play detective and figure out if the debt is a tool for smart growth or a symptom of a deeper problem. ==== The Good, the Bad, and the Ugly Debt ==== Not all debt is created equal. When you look at a company's [[Balance Sheet]], try to categorize its loans: * **Good Debt:** This is debt taken on to finance projects that are highly likely to generate returns well above the interest cost. Think of a profitable company borrowing to build a new, highly efficient factory. This is productive debt that creates long-term value. * **Bad Debt:** This is debt used to plug holes or for financial engineering that doesn't add real value. Examples include borrowing to cover operating losses or to fund a massive [[Share Buyback]] when the stock price is already sky-high. It's often a sign that the core business is struggling. * **Ugly Debt:** This is high-interest, short-term debt, often with strict conditions (known as [[Covenant]]s). It's a major red flag that the company might be desperate for cash and that traditional lenders see it as too risky. ==== Key Ratios to Watch ==== You don't need a PhD in finance, but a few simple ratios from a company's [[Financial Statements]] can tell you a lot. - **[[Debt-to-Equity Ratio]]:** This compares a company's total debt to its shareholder equity. It gives you a snapshot of its leverage. A high ratio (say, over 2.0) can signal high risk, but context is key. Some industries, like utilities, naturally operate with more debt than others, like software. The formula is: Total Liabilities / Shareholder Equity. - **[[Interest Coverage Ratio]]:** This is the acid test. It measures a company's ability to make its interest payments from its operating profit. A higher number is better. A ratio below 1.5 is a serious warning sign, as it means profits barely cover interest costs. The formula is: [[EBIT]] / Interest Expense. ==== Reading the Fine Print ==== The numbers only tell part of the story. The //notes// to the financial statements are where the secrets are buried. Here you'll find crucial details about a company's loans, including: * **Maturity Dates:** When does the debt need to be repaid? A "debt wall" – a lot of debt coming due at the same time – can be a problem. * **Interest Rates:** Are they fixed or floating? Floating rates can become very expensive if market interest rates rise. * **Covenants:** These are rules the company must follow, like maintaining certain financial ratios. Breaking a covenant can allow the lender to demand immediate repayment, which can trigger a crisis. ===== The Bottom Line ===== For a value investor, loans on a company's balance sheet aren't inherently good or bad. They are a tool. Your mission is to determine if the management is a master craftsperson using that tool to build a stronger, more profitable enterprise, or a reckless amateur taking on risk that could bring the whole structure crashing down. By asking //why// the company is borrowing and checking if it can comfortably afford the payments, you can turn a company's liability section from a source of fear into a source of insight.