Issue #10 - Becareful of debts

Taking the example from Issue #8, the rental property generates at 48% of ROE but at the same time having RM90,000 in long term loan debt. Net earnings from rental are reduced if a portion of it are used to payback the loan as installment. Loan to earnings ratio is a quick way to measure the size of loan and how fast the loan can be repaid using the earning capacity of the property. In this example, the debt-to-earnings ratio is 18.75 (=90,000/4,800). This means the property, through rental income, can pay off the debt in 19 years.

The same ratio can be use to measure the size of the long term debt of a company. Debts reduces cash from earnings to be retained and invested elsewhere or to be payout as dividend for shareholders.

Key points from "The New Buffettology" (Buffet & Clark, 2002):
1. Companies with a durable competitie advantage typically have long-term debt burdens of fewer than 5 times current net earnings

Below are debt to earnings ratio of SP Setia and Island & Peninsular.

SP Setia
Years   Debt-to-earnings
2005    2.35
2004    3.02
2003    5.59
2002    4.12
2001    2.06
2000    3.03
1999    1.18
1998    0.97

Island & Peninsular
Years   Debt-to-earnings
2005    4.98
2004    1.89
2003    9.52
2002    0.00
2001    0.00
2000    0.00
1999    0.00
1998    0.00

Looking at the latest ratio (Year 2005) for both company, earnings capacity of SP Setia and Island & Peninsular allow them to pay off their debt in 3 and 5 years.