Welcome to Boosting your Financial IQ, where we talk about business, finance and how to increase your confidence as you speak the language of money and apply these principles to drive greater financial value in your company. Please share and enjoy. Let's debunk a myth Is there such thing as good debt or is all debt bad debt? Now some pundits out there will say look, all debt is bad debt and you should definitely avoid it at all costs, and that can be true for some people, especially if you don't have discipline or if you don't follow the principles that I'm going to teach you in this episode. So check this out. There are two different types of debt. Right, one is asset based and then the other one is liability based. Guess which one is worse? Ok, the the other one is liability-based. Guess which one is worse? Okay. The liability-based one is worse because with asset-based debt, you're using leverage to buy assets that ultimately generate income, and then you can take that income and reinvest it in assets which will produce even more income. So you're servicing the debt, you're paying down the debt. You're gaining more equity in this asset as time goes on. So you're servicing the debt, you're paying down the debt. You're gaining more equity in this asset as time goes on and you're building wealth. Now, on the other side of the equation, you have debt that is liability-based, and this is when you swipe that credit card to go on the vacation that you really wanna go on, but you can't afford. Or when you're pouring money into your business, but your operating model is broken. It's terrible and it's just going to go right down the drain. You're going to cover payroll, you're going to cover your expenses, but guess what? The same problems are going to exist and profit isn't going to improve, and neither will cashflow, and therefore you're just dumping more and more and more debt into the business. All right, so you want to avoid that. So let's break down this concept and let me share some lessons that I've learned along the way.

When it comes to investing in assets, the key is to understanding how much cash flow these assets will produce. So you have to start with revenue, understand the expenses. Ultimately, you get down to profit, but then you also have to account for changes in working capital and other future capital expenditures that are going to be made in order to keep this asset running. Whether it's a business, or whether it's a factory or whatever it may be, there's oftentimes working capital and CapEx that's associated with these returns. That's why you can't just look at the returns on the investment always. In other words, you can't just take the profit and compare that to the asset, because profit may not be the same thing as cash flow. So that's number one you have to evaluate how much cash that asset is going to spend off. Then you have to evaluate whether or not that cash is sufficient both in good times and in bad times, or in other words, during your worst case scenario, in order to cover the debt.

One time I bought an apartment complex with a partner out in Kentucky and it was a multi-unit property. It was a lot of money and when we were doing our evaluation, a multi-unit property is a lot of money. And when we were doing our evaluation I built out this beautiful discounted cash flow model and I wanted to see what did our returns look like from an IRR perspective and a net present value perspective and cash on cash and all these other metrics. But in order to get there, I had to make several assumptions, for example, the occupancy rate or the amount of money we were going to be able to charge based on some enhancements we were going to make to the property. So I built out the model and I had three scenarios Number one, the worst case scenario, the middle case scenario and then the best case scenario and, based on each of these scenarios, I looked at the cash flow and, after talking with my partner, we agreed that we weren't going to go out there and raise capital and invest in this property unless we could service the debt under the worst case scenario. And that was true. So when you're looking at using debt to buy an asset and you're evaluating how much cash is going to be generated from this asset, make sure you look at different scenarios.

Don't just look at the bright and sunny side of things, because you may invest in an asset in a time when the market is optimal. You also want to look at the downside, to ensure that you're not going to get yourself in a bad situation. So if you can invest in assets that produce a healthy amount of cash flow and then you use this cash flow or this income to reinvest in other assets, you're going to build wealth very, very quickly. Now, on the other side of things, let's look at our personal lives. Oftentimes, we'll use debt to buy a home or to buy a car.

Now with a home, there's some people that say, look, buying a home is a terrible investment. Others will say it's a great investment because you get to realize the upside of equity. But think about it All your money is going to be tied up in that home. So I'm not advocating for one approach over the other. I just want to point things out. But sometimes investing in a home may not be the best investment, or even sometimes paying off your home may not be the best use of your leverage, especially if you have a mortgage that's like three or 4%. Basically, you're getting money for free, but regardless of the case, you have to ask yourself okay, is this asset that I'm investing in producing expenses and liabilities with the home? It is. You have home repairs, your roof starts to leak, you have to remodel the bathroom or whatever it may be. Money's going in to this asset. That's why it's TBD on whether or not it's a good thing or not.

Or think about a car. You go and buy a car and that may be necessary for a lot of people out there. I'm not poo-pooing this, but if you overextend yourself on a car, think about it as soon as you drive it off the lot, it immediately loses value. So I can't think of a single investment you or I would probably be comfortable with and investing in, and then the next day it loses 10% to 15%. I mean, that'd be crazy. I mean, can you imagine buying a stock and say, okay, you're going to buy Chipotle today, and tomorrow it's going to be worth 10% less. It's going to drop by 10%. You'd be like, oh my gosh, you'd freak out, right. Well, the same thing is true with certain types of debt. So we just have to be careful. I'm not saying it's bad to go buy a car and to use debt in order to buy one. You just have to be mindful of this and how it impacts your financial future.

Now, you can't just put everything in the same bucket. For example, you can't say vehicles are bad debt, investments over here are good debt. Okay, you can't, because you can buy a vehicle and then you could turn it into a service truck. For example, let's say you have an electrical company and then you're producing income off that truck that has debt associated with it. Well, guess what? That's good debt because you just bought an asset that's producing income. If you're going on vacation or if you're buying that shirt you can't afford or whatever it is, and you're swiping the credit card. You're just going to be accruing more expenses interest expense which will then require you to assume more debt, and then you just get yourself in this really dangerous trap.

The same thing is true with businesses. I spent my entire career turning around and growing businesses. Some companies, they're using their line of credit or they're using other forms of debt to keep a business on life support, and oftentimes I'll tell these owners I'm like look, your operating model is completely broken and you're just drawing on your credit card or your line of credit to make payroll For what Things are going to improve, your profit's not improving and you're just going to accumulate more and more debt until you fix your business. Now, if the business is not fixable, then maybe that's the answer, but for a lot of companies, you can make adjustments and improve performance. So if you're dumping money into your business but you're not making strategic moves to improve performance, well, guess what? You're just going to be accumulating debt and you're going to put yourself in a very precarious position. So be careful of that. I've come across a lot of people that are in that trap. So if you have debt. How do you know if you have too much debt? Let's just talk about things from a business perspective.

There are two ratios to consider. Number one measures leverage how much debt you're taking on and coverage your ability to service that debt. So the first ratio to do in business is debt to EBITDA. So you take all your interest-bearing debt, both your long-term and your short-term debt. Don't include your trades payables, for example, your accounts payable. Just don't include those in the calculation because that's trade debt. Instead, look at interest-pairing debt and then compute your earnings before interest, taxes, depreciation and amortization and do the math and you're going to come up with some number. Now, 3x and below is considered healthy. Now for some industries, leverage is more common. Let's just say you're in a capital-intensive industry and you have to invest in more CapEx, which requires more and more debt. Maybe you could get away with 4 or 5x with this ratio, but I'd say once you start getting above 6x, you're starting to flirt with danger here. Okay, so do the math in your own company and see where you land as far as a leverage ratio here.

Debt to EBITDA. Now the next metric to measure is your coverage, and this is your debt service coverage ratio. You compute this by taking net operating income and dividing it by your total debt service, which is your principal and your interest on your debt, and if you come up with a ratio of 1.25 or greater, then you're in a good position. If you're less than that, oftentimes banks won't even lend to you if it's less than this amount. So 1.25 and above is a good rule of thumb for your coverage ratio. So anything greater than that is bueno. Okay, so there you have it. That's how you measure leverage and coverage. Now here's a bonus for you.

What I like to do is build out a forecast, and in my forecast I have different types of ratios. I'll look at my return on invested capital. I'll also look at my leverage and my coverage ratios, and then, as I look into the future, I can see if I'm going to be creeping into risky territory. In other words, if my ratios start falling below these amounts, in my future forecast, I may spot early on that there's danger ahead. So I'd highly recommend building these metrics into your forecast as well as your normal monthly reporting process.

Now the final thing I'm going to touch on is return on invested capital, and this is related to this discussion. When I work with companies, oftentimes I'll go in and I'll measure the return on invested capital and it's below what it should be. In other words, I was working with a business not too long ago and the return on invested capital was 5%, which was far below the industry average. Now this owner had been at it for years, for about 15 years and there's a big difference between having a low return on invested capital. Now there's a difference between having a low return on invested capital because you're just starting out right or you're transforming the business and you just have a one-off year here and there. I get that. But if you're consistently the business and you just have a one-off year here and there, I get that.

But if you're consistently earning a return on invested capital that is below industry average, you may have a problem in your business. You may actually be destroying value in your company. Also, just a side note sometimes return on invested capital doesn't always work, especially if your investments are lumpy in the beginning or if you're a capital light business. So if you have a capital light business model, then return on invested capital may not be as appropriate as an alternative like economic profit, but nonetheless, as working with this business. They're earning a 5% return on invested capital and I was like look, I mean you could take your money and go put it in a money market account for like 4.25% right now, so why take on all the risk?

Now I'm not saying if you have a low return on invested capital, that you should just close down the business, throw the baby out with the bathwater and start over. I'm not saying that at all. I'm trying to illustrate the point that if you're just looking at your income statement and you're looking at your bottom line, you may be celebrating Yay, I got net operating profit after tax of 10%. We're great. But when you consider the invested capital that has gone into the business and the returns that you're earning on it, you may find out that the story is wildly different.

Now for this owner, he's earning a 5% return. Now compare that to the overall stock market. That's returned what? 10 to 12% over the last 50 years, depending when you're measuring it. Nonetheless, he was far below what equities were returning out there in the market. So it's like okay, you got to make some changes.

And that's why I'm such a huge advocate for strategy and finance, putting in place a strategy and determining where are we going to compete, how are we going to compete and how we're going to win, and what types of returns are we going to earn on this strategy if we pursue it, and then measuring things along the way? So I just wanted to tie that in, because that's another measure you can use when you're evaluating income-producing assets and whether it makes sense to leverage up. You can look at return on invested capital, and that can be really critical in your decision-making process. All right, so there you have it. That's how I like to look at debt from an asset-based and a liability-based position, and that's all I have for you. So in the meantime, please be sure to share this episode with others so we can help spread the word and take care of yourself, cheers.