• How To Estimate an Optimal Debt Ratio - Special Cases
  • How To Estimate an Optimal Debt Ratio - Special Cases
  • How To Estimate an Optimal Debt Ratio - Special Cases
Originally published: 26/03/2018 10:02
Publication number: ELQ-18878-1
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How To Estimate an Optimal Debt Ratio - Special Cases

This video will show you how to compute the optimal debt ratio for a company.

commodity companycyclical companydebt ratio exampledept ratio calculationoperating incomeoptimal debt ratio

Description
In this video, Professor Aswath Damodaran demonstrates how to calculate the optimal debt ratio for a company without relying on the financial statements of the last financial year. Aswath suggests that while these recents will provide you with the most up to date numbers, they do not represent an accurate indicator of long term borrowing capacity. Here, he demonstrates his alternatives, helping you to more accurately calculate your company's optimal debt ratio.

The biggest driver of optimal debt ratio is the business' operating income if your operating income is low - unable to borrow money - no tax benefits

To begin, Aswath explains why the biggest driver of your optimal debt ratio is the business' operating income. He demonstrates the reasons why you will be unable to borrow money if your operating income is low, highlighting that operating income is essential to driving your optimal debt ratio.

Next, he highlights the problems that can arise when using the financial statements o the last financial year to calculate optimal debt ratios. According to Aswath, this way of calculating optimal debt ratios can create problems with Commodity or Cyclical companies, companies that have had an unusually good or bad year as well as companies that play "operating income games".

As such, Aswath suggests a different approach to optimal debt ratios for cyclical companies determining debt capacity with normal income. Aswath argues that because the judgement on debt capacity is made with a long term view, you should be borrowing on income that you can generate across a cycle and now just the most recent year. Aswath shows how you can normalise your income in order to establish a normalised figure with which you can calculate your optimal debt ratio.

He then goes on to try out his methods on several companies, such as Turkish Air, as examples. He demonstrates how you can calculate the optimal debt ratio for each of these businesses with the help of visual charts. As such, he makes his methods for calculating an optimal debt ratio easy to understand and apply to real-world business.

He then breaks down the process of optimal debt ratio calculation for commodity companies. Again, he puts this into the context of Royal Dutch Shell, to quickly and easily demonstrate his methods for calculating the optimal debt ratio for a commodity company.

Again, he does the same with companies playing 'operating earnings games', to show how you can get around the problems of calculating optimal debt ratio.

12 mins 25s

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