Matthew Benjamin: Hi, I'm Matt Benjamin, the Editorial Director here at The Oxford Club. Welcome to Investment U's Getting the Market Right.
Our guest this week is Steve McDonald, the Club's Bond Strategist. He's here to talk about debt-to-cash and debt-to-cash-flow ratios, and why he thinks they're some of the key numbers you should look at before you buy a bond.
Steve McDonald: Thank you, Matt.
MB: We've turned the tables on you this week, right?
SM: Yes, and I appreciate your doing this. It's hard to interview yourself.
MB: Absolutely, I understand that. So, Steve, tell us, what is debt-to-cash and debt-to-cash-flow, and why should we focus on them?
SM: When you're looking at a bond, whether it's a corporate bond or a tax-free bond - this really doesn't apply to Treasurys because they have unlimited cash flow; the government just prints money whenever it needs it - but with corporations and municipalities that issue bonds, the first thing you want to be certain of is this: Do they have the money to pay their bills?
And the first bill that they always pay is the interest on their debt, or the interest they owe to us as bondholders.
So the first thing that I look at is the total cash amount and the cash flow. Now, cash is very simple. How much do they have in real cash - in short-term instruments that they can get to in a hurry if they need it? I think some even include stuff as long as two- and three-month maturities.
So the cash number can vary, depending on when you look at it. But let's say a corporation has $5 billion in debt - if it's only got a couple of hundred thousand dollars in cash, that's a red flag.
I would like to see, out of $5 billion, at least 10% covered by cash. Maybe $500 million, somewhere in that area. And that's a ballpark - this is all relative.
Now cash flow is a totally different issue. Cash flow is how much money comes in the front door and how much is available to be spent.
It isn't necessarily the amount of cash, but how much of the money coming through the corporation - and it's a simple explanation - can it use (if it has to) to pay its bills for capital expenditures, development and all those sorts of things?
Why do we focus on it? We focus on those two because there's only one thing a bondholder has to worry about: Does a company have the ability to pay its bills?
I don't care if it makes money. I don't care if its earnings grow. I don't care what its new products do. I don't care what its CEO does. As long as it's got the cash and the cash flow to pay that bond, we're going to get paid. And that's the first priority with a bond.
MB: Absolutely. So you talked about a few numbers there, but just give us a real good example here of some levels you look for in terms of cash-to-debt and cash-flow-to-debt ratios.
SM: The ideal situation - we had one that came very close a week or so ago - was a company that had about $5 billion in debt, and it had something like $4.5 billion in cash. That's the ideal situation.
But what I do is just a rough guesstimate. I look at its total debt - and let's say it's $5 billion - and I do a quick calculation in my head. I say, "What's the worst-case scenario that it can owe in interest, as a percentage?"
So I run 10%. I look for a minimum of 10% of the debt. But again, that's going to fluctuate depending on cash flow. You know, it may not have 10% in cash. But how much is it showing in cash flow? Because it can access that too to pay us, the bondholders. So it's a combination of the two, and I kind of massage it.
When you hear the term "overleveraged balance sheet," that means it doesn't have enough cash or cash flow to cover that debt. Or people are beginning to worry about it. And that's when the credit rating starts to fall.
One of the things most people don't understand is that a company can do everything right with earnings, earnings growth and revenue growth but, if it's overleveraged, its credit rating is going to come down. The credit rating agencies don't like people who owe too much money and don't have the cash or the cash flow to cover it.
MB: They certainly don't.
So these numbers - this information is critical for making any of these kinds of investments, Steve. Where can our Members at The Oxford Club go to obtain it?
SM: My two primary sources are Yahoo Finance - that's always what I call my "quick glance." If you bring up a company's stock listing, go to "Statistics," then go all the way down on that page on the left-hand column, and you will see "Cash," "Total Debt" and then just below that "Cash Flow."
So that's one place you can go. But one of the problems I've run into with Yahoo on these particular debt numbers and cash numbers is they can vary from the S&P report, and that's another place where I go.
And most people don't know this, but if you have a Fidelity or a Vanguard account, you can access their research center, and most of these online folks will give you free access to an S&P report.
In the upper-right-hand corner, as you're going down the narrow column on the S&P, the total debt, total cash and cash flow are listed there as well.
Now the ideal situation is to go to Bloomberg, but very few people have access to a Bloomberg machine. I think it's $25,000 a year to use. But that's my third place that I check. When I send in a bond recommendation or a commentary, members of my research team go to the Bloomberg Terminal and back up my numbers.
And very often they change them slightly. It's not a huge difference, but if we see a discrepancy - we haven't really been able to explain why there's a difference between Yahoo and S&P - but that's where you go to get this stuff.
MB: Okay, totally makes sense. So if I get you right, the matter is can it pay the bills - that's what matters to bondholders, right?
SM: That's exactly right.
MB: And cash and cash flow will tell the whole story about whether it can or cannot, right?
SM: Yup, exactly. They're the two primary indicators that I look at.
MB: Absolutely. Okay, Steve, that makes sense; that sums it up. I want to thank you again for being on your own show!
SM: Thank you, Matt!
Disclosure: We expressly forbid our writers from having a financial interest in their own securities recommendations to readers. All of our employees and agents must wait 24 hours after online publication or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Investment U should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.