What is debt?

Figuring out how much debt a company has outstanding is not only critical to assessing its default risk but is a central input into much of what we do in corporate finance (cost of capital, cost of equity and valuing equity). It is a topic we have been examining in both the corporate finance and valuation classes this week. 

I use three criteria to classify an item as debt. 

1. It gives rise to contractual (fixed) payments that have be made in both good times and bad.

2. These payments are tax deductible.

3. Failure to make these payments results in loss of control

Using these criteria, it is quite clear that all interest bearing debt (whether short term or long term, bank loans or corporate bonds) should be considered debt. Here are the more controversial items:

a. Accounts payable and supplier credit:  Generally, I would not include these items as debt and here is why. The interest expenses on accounts payable and supplier are not explicitly broken out. Consider how supplier credit works. You buy items from a supplier, and he lets you pay in 10 days or 50 days. If you pay in 10 days, you get a 2% discount, which you lose if you take the entire 50 days. When you use supplier credit to increase your cash flows, you give up the discount, which effectively is the interest you are paying on the credit. However, when you account for the expense, you record the total cost you pay as part of cost of goods sold and do not break out the discount lost as an interest payment. So, here is the trade off. If you want to count accounts payable as debt, you will have to go into your cost of good sold and break out the portion of that cost that is the foregone discount and show it as interest expense. That can be tough to do.

b. Lease commitments: By the same token, lease commitments should be treated as debt because they are (a) contactual commitments (b) tax deductible and (c) failing to pay them can expose you to legal consequences. We can debate whether they are closer to unsecured debt than secured debt, but not whether they are debt. For any retail or restaurant company, the bulk of the debt is in the form of  lease commitments and we should be considering the present value of these commitments as debt. For firms like the Gap, Walmart and Starbucks, 80-90% of the debt takes the form of lease commitments.

c. Under funded pension and health care obligations: We are trained in accounting classes to be conservative when it comes to debt and to count everything we can as debt. That advice serves us badly in valuation. If we start including under funded pension and health care obligations as debt, we will inflate debt ratios and reduce cost of capital. That does not strike me as conservative. I would ignore these as debt for cost of capital purposes, but will consider them as debt, later in the valuation, when I am intent on getting from firm value to equity value.

More posts on this as we go on, but that is it for now.