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Debunking a Myth: Is There Such Thing as Good Debt?

Is there such thing as good debt? Or is all debt bad debt? Some pundits say that all debt is bad and should be avoided at all costs. While this can be true for some people, especially if they lack discipline or don’t follow certain principles, it’s essential to understand the differences in debt types.

Types of Debt: Asset-Based vs. Liability-Based

There are two types of debt: asset-based and liability-based. Asset-based debt involves using leverage to buy assets that generate income, allowing you to pay down the debt, gain equity, and build wealth over time. Conversely, liability-based debt is associated with non-income-generating activities, like using a credit card for an unaffordable vacation or pouring money into a failing business model.

Investing in Assets

When investing in assets, the key is to understand the cash flow they will produce. Start with revenue, understand the expenses, and get down to profit. However, account for changes in working capital and future capital expenditures needed to keep the asset running. It’s crucial to evaluate whether the cash flow from the asset is sufficient to cover the debt, even in worst-case scenarios.

A Real-Life Example

For example, I once bought an apartment complex with a partner. We built a discounted cash flow model with three scenarios: worst, middle, and best case. We agreed to invest only if we could service the debt under the worst-case scenario. Evaluating different scenarios is essential to avoid bad investments and ensure financial stability.

Personal Finances: Debt in Our Lives

In personal finances, debt is often used to buy a home or a car. While some argue that buying a home is a terrible investment, others see it as a great opportunity for equity. However, it’s crucial to recognize that homes and cars come with ongoing expenses and liabilities, making them potentially poor investments depending on individual circumstances.

Business Debt: A Double-Edged Sword

In business, using debt to keep a company on life support without fixing underlying issues is dangerous. Accumulating debt without making strategic moves to improve performance puts the business in a precarious position. It’s essential to measure and manage debt to avoid this trap.

Ratios to Measure Debt

There are two critical ratios to measure business debt: leverage and coverage. The debt to EBITDA ratio measures leverage, with 3X and below being considered healthy. The debt service coverage ratio measures coverage, with a ratio of 1.25 or greater indicating a good position. These metrics help assess whether a business is taking on too much debt and its ability to service that debt.

Forecasting and Return on Invested Capital

Building a forecast with leverage and coverage ratios helps spot potential financial dangers early. Additionally, measuring return on invested capital (ROIC) is crucial. Consistently low ROIC compared to industry averages may indicate that a business is destroying value. Strategy and finance should be integrated to determine how to compete and win while achieving desirable returns.

Conclusion

Understanding the differences between asset-based and liability-based debt is vital for making informed financial decisions. By evaluating cash flows, using debt wisely, and measuring key ratios, individuals and businesses can manage debt effectively and build wealth.