Friday, July 24, 2009

All Debt Not Created Equal

Regular readers know that, as value investors, we generally prefer companies with relatively low debt levels. The reason for this is that companies with low debt levels will fare much better than their competition during times of economic distress, providing for better downside risk protection. But looking only at a company's debt level does not provide a complete picture of a company's risk related to its debt, as even similar companies with identical debt levels can vary dramatically in their debt-related riskiness.

Consider Escalade (ESCA), the world's largest producer of table-tennis tables (and other gaming items). Escalade has long-term debt of $45 million. To give an idea of the relative size of this debt, consider the fact that Escalade has averaged $9 million of operating income per year over the last four years.

But while the debt is listed as "long-term" because it is not due within 12 months of the most recent financial statements, "long-term" is hardly an accurate description. All $45 million is due in May of 2010, just 10 months from today!

Practically speaking, this represents a huge difference to a situation where the debt is not due for 10 years. Added time to maturity allows the company to plan accordingly, building up cash reserves from operations or other sources of financing in due time. Instead, this company is reliant on a debt market that is shaky and expensive for this type of company. As a result, the company will likely have to sell some of its assets at the current market's firesale prices!

An important complement to what debt is due (found on the balance sheet) is when the debt is due, which can be found in the notes to the financial statements.

Disclosure: None

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