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How to Analyze the Debt of a Company - YouTube
Channel: Learn to Invest - Investors Grow
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Hi, I'm Jimmy and this video we're looking at how we can
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analyze the debt of a company.
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So I'm sure that most of us know that interest rates have
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been dropping. And as we could guess, many companies
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have taken out more debt, in some cases a lot
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more debt because of those falling interest rates.
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Now, this is not always a bad thing.
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Sometimes if you take out some additional debt and let's say
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you're paying 4 percent of that debt, we can grow the company
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by 10 percent or 8 percent.
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That's a logical thing to do, assuming you can manage the
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debt. So let's look quickly at how the debt affects a company
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and where we can find the impact of that debt on different
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financial statements and ultimately what it could mean
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for those companies.
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What are the risks? What benefits?
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And hopefully we can use this information to get us closer to
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our personal goal of achieving financial independence.
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Okay. Now, I did a video a while back where I tried to walk
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through how to calculate the fair value of a company using
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a discounted cash flow valuation technique.
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Here's a link in the description below, if you're curious.
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But the reason that I bring that out in this video is that in
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that video I used Apple, the company, as
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our example to sort of examine how we can come up with
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a calculation. And since then, I've gotten quite a few
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questions as to how I came up with their debt numbers.
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I figured I could use Apple as our example once again in
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this video and simultaneously hopefully
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clear up where I got those debt numbers from sort
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of two birds, one stone.
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OK. Sorry. So let's kick it off.
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So this is Apple's balance sheet from the last
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annual report. And as we could see, well, they're showing
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both numbers for twenty nineteen and for twenty eighteen.
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We're mostly going to focus on the twenty nineteen numbers
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since those are the most recent numbers, most recent annual
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numbers. But when I reference the DCF video
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we're going to be looking at the twenty eighteen numbers.
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OK, so first let's look at how the balance sheet is broken up
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and as we could see, all balance sheets are broken into.
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Three main sections, assets, liabilities
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and then shareholder equity.
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OK, simple enough. So the most popular type of debt is
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when a company takes out of bond or the issue of bond power
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to the public wherever it goes.
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And that's mostly where we're going to focus on now.
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Many investors know that liabilities represent
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what the company owes, but a few times I've seen
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liabilities mistaken for debt.
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And just so we're on the same page, liabilities and debt
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are not the exact same thing.
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So they're not really the same thing as an example.
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Each of us have our own households, our own personal family,
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whatever it is. Let's imagine that we have a Netflix account.
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Well, if we have a Netflix account, that is a bill
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that we owe each month.
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But I wouldn't really qualify.
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That is debt, although that would show up in the accounts
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payable section of the liability.
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So it is a liability, but it is not the same thing as debt.
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So that's just an example.
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What we're really looking for here is we're looking for term
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debt that falls into both the current liability section
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and the non-current liability section.
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Now, just so we're all on the same page.
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Current liabilities are are items owed by the company
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within the next 12 months.
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Within the next 12 months. Anything beyond that is
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non-current liabilities.
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So this term debt is the debt from
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that Apple owes from the bonds that they've issued.
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And if we're curious for the DCF video, this is where I got
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their total debt numbers from.
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I added up the short term portion of their debt,
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of their term debt and the long term portion of
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their term debt. And I use that to calculate Apple's total
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debt. OK, so now we know this is where the bond show up and
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the balance sheet. But let's look a bit closer, because bonds
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actually affect all three financial statements.
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OK, so just to illustrate, let's imagine that Apple went
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ahead and they issued 100 million dollars in new bonds.
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Well, that hundred million dollars would fall
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right here on their on their balance sheet.
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But because they sold 100 million dollars in debt,
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they also received a hundred million dollars in cash.
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That cash would appear appear on their balance sheet.
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Two sides are in balance because one hundred million went to
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both assets and liabilities.
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OK. Now let's jump over the cash flow statement.
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So once again, cash the cash flow statement is divided into
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three different sections. Very similar to the balance sheet.
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The top section focuses on cash spent and
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generated from the normal operations of the business.
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Then we have cash flow from investing that focuses
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on the sale and purchase of maybe
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buildings or if they bought stock in another company or they
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sold it, or if they were, let's say they replaced
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a roof of one of their own manufacturing plants.
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Well, that would fall into the cash flow from investing
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parts, since in that case they would be investing in
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themselves.
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OK, simple enough. Then we jump down to the third and final
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section cash flow from financing.
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And this is where we are going to focus.
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So this section is clearly where the new one hundred million
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dollars that Apple just issued in bonds.
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Would appear. And if we're curious, it would appear right on
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this line item titled Proceeds from the Issuance of term
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debt. OK.
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Logical. Now, if they paid off debt, then would appear
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in this number. So as you can see, we start to get this story
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coming together and understanding these different line items
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from just from debt is a smart thing to pay attention
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to. So if they issued stock, well, that would appear here.
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And if they issued dividend payments, that would appear
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there. So the financing should section
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of the cash flow statement tells us how the company raises
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money or pays back money, anything like that would end
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up in this section. OK.
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Now, this brings us to the income statement.
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And this is also where we can see the impact of debt in
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general on profits or earnings per share or price
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to earnings ratios.
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Now, this is where this one Apple's income statement looks
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like. And when I was prepping for this video is actually
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scratching my head for a second because I knew that I was
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looking for a line item called interest expense.
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And clearly, we don't see that when it should appear right in
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this section. Now, as I read through each of these line
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items from this section, the only logical place that interest
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expense could be hiding is in other income slash
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expenses.
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So I went ahead, check the footnotes.
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And if we ever can't find something that, you know, should be
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there many times, many, many times the footnotes
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is where we will find it. I happened to find this in footnote
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number seven. And now, as we could see, Apple's interest
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expense is about $3.6 billion.
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And this is where it gets interesting.
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So our question is, is that too much debt?
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Well, if I saw personally nothing but this one
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footnote, I can make a fairly educated guess.
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I can be fairly confident about my guess that an apples case,
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this is not too much debt.
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In fact, I can also guess that they must have a ton of cash
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and short term investments since their interest in dividend
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income is almost 5 billion dollars.
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So basically their interest in dividend income in this
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case is bringing in more than Apple's interest
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expense. So this is a great position for any company
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to be in.
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Now, to get a bit broader about a company's
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debt in general, to drift away from the apple in isolation.
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How do we know if a company's debt is, let's call it
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manageable? So for that, we can look at a few things.
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First, let's jump back to the income statement real quick.
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Now we know that the interest expense falls into this other
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category. So it's smart for us to look
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at operating income, which is right above it.
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So now the question is, is Apple's interest expense
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of about 3.6 billion dollars?
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Is it too much?
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Well, given the size of their operating income, even if they
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doubled their interest expense from 3.6 billion
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to 7.2 billion, well, they still have tons of operating
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income room to cover that.
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Now, what if operating income, on the other hand, was just 6,
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6 billion dollars?
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We'll compare that to their current level of 3.6 billion
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interest expense.
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And they don't have a lot of wiggle room there.
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And to me, that would be very dangerous for a company that
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would be borderline too much debt,
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economic recession, a pullback in revenue and therefore a
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pullback in operating profit.
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Well, that would expose this company to default risk if
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they only had $6 billion dollars while simultaneously having
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an interest expense of 3.6.
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Now, we should also check our cash flow statement and just so
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we're on the same page. A rough estimate of free
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cash flow is calculated by taking the cash flow from
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operations and subtracting capital expenditures.
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That's what this line item is.
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They don't always call the capital expenditures, but that's
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what it is. Now, if we do that math real quick, we
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can see that they have free cash flow of about fifty nine
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billion dollars. And once again, when we compare this to the
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interest expense of 3.6 billion, they have more
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than enough room to cover the interest expense.
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But another check that makes a lot of sense to do is jumping
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back to the balance sheet. And I actually like to do this one
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first. I oftentimes like to start with the balance sheet.
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And there's two main things that we're looking at.
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First, under current liabilities, well, we know that the term
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section of our current liabilities don't forget current
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liabilities or liabilities owed over the next twelve months.
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We can see it's about 10 billion dollars, but we know that
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their interest expense is about 3.6 billion
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right there. That would tell me that at least some of their
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bonds are going to mature over the next
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twelve months. That's why that numbers so much higher than
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the interest expense. So the first thing we can do is do they
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have enough cash to cover that right now if they needed to?
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And clearly, when we look at these two line items, whether
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they've got more than enough cash to cover it now,
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if this was a bit closer.
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Another thing we could check is we could check the free cash
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flow numbers that we get, that we check that we calculated a
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moment ago. Does free cash flow, will that
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cover the total amount to the term debt
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due in the next twelve months?
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If it did, maybe they don't need the cash right now.
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Maybe they use the cash for an acquisition or something.
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Now, another thing to consider is oftentimes a company will
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simply issue a new bond and pay off the old
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bond. So really just kick the can down the road.
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But let's imagine that the first bond was issued five
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years ago, 10 years ago, 10 years ago, maybe interest rates
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were 6 percent. Maybe they're maybe they're 7 percent
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today. They might issue that very same bond, same amount.
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But this time it's a 3 percent or 4 percent.
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Well, if that would happen, that the company would end
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up with a lower interest expense on
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an annual basis.
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What does that mean? Lower interest expense?
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Higher profits on the income statement?
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Higher profits on the income statement leads to higher free
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cash flow because that would mean higher cash flow from
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operations. Hired free cash flow makes
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everything look better.
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And this is one of the reasons that many people
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believe this is just another contributing factor, that when
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lower interest rates happen, will companies tend to do
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better? So is does when does a
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company have too much debt?
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Well, if they keep dropping interest rates, you can
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really just keep kicking the can down the road.
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Now, I do think it's important that a company not overload
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on debt because then it becomes very, very difficult for them
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to manage once interest rates tick the other way.
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But we can see that happening.
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We can we know we can figure out on their income statement,
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not on their consumer and their annual report.
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They usually tell you how much debt is due soon.
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If interest rates roll up, we'll know that this is beginning
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to be a problem. So I think these are good things to pay
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attention to a good things for us to watch for.
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Now, I don't want to completely disregard all the other line
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items on the balance sheet because I think that it's
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important to look through each of them and see if any
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unusual things jump out at us.
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Now, if you don't know if you want a better understanding
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of how to read many of the different line items of a balance
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sheet actually didn't video where I walked through
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analyzing a balance sheet. If you're curious, there's a link
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right here in this link in the description below.
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And I want to thank you so much for stick with me all the
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way. End of the video. I hope you found this interesting.
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Thanks so much. I'll see in the next video.
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