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In the book Warren Buffett and the interpretation of the financial statements, Mary Buffett explained companies that have enough earning power to be able to pay off their long-term debt in three or four years are good candidates in our search for exceptional companies with a sustainable competitive advantage.

Question: How could I compute if the company has enough earning power to pay off their long-term debt in less than 4 years? Do I have to divide the long-term debt by the net income? For instance, for Coca-Cola in December 2021, the long-term debt is about 38,130 M$ and its net income is 9,771 M$. So for Coca-Cola, they are able to pay their long-term debt in about less than four years. Does it make sense?

EDIT:

Here is Alibaba between March 2013 and March 2022:

Alibaba ratios Here is GM between December 2012 and December 2021:

GM ratios

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  • In the screenshots, is the latest value on the left or on the right?
    – Flux
    Sep 21, 2022 at 14:26
  • @Flux The recent ones are on the right and the oldest on the left
    – J.Doe
    Sep 21, 2022 at 14:53

1 Answer 1

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Debt to Income is certainly a ratio that could be used - meaning if debt is 4 times the annual income, then theoretically the long term debt could be paid off in 4 years. It obviously doesn't mean that they will pay off their debt, and certainly isn't a guarantee of success, but it would fit Buffett's criteria.

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  • Someone told me: ''Not quite because in the net profit we find, for example, expenses that do not generate an outflow of capital (such as depreciation), we find expenses that we would not have if we had no debt (such as interest expense). There are also taxes that should be excluded from expenses as well. A better indicator for what you want is the Total Debt divided by EBITDA.'' What do you think about it?
    – J.Doe
    Sep 20, 2022 at 18:18
  • But the point is that they DO have debt, so those expenses are valid. I could see using free cash flow instead of Net Income, but that's nitpicking IMHO. Buffet's point is that the more earnings you have relative to your debt load, the "healthier" you are in the sense that you can still service your debt even if earnings drop somewhat. It's not wrong to use EBITDA but when using comparative metrics like that you need to be consistent.
    – D Stanley
    Sep 20, 2022 at 18:38
  • Yes, it is not wrong at all. You are not the only person to suggest using the free cash flow instead. I am not sure how to use it to create a usable ratio. What should I use, i.e. FCF, Net Income or EBITDA? I am still confused.
    – J.Doe
    Sep 20, 2022 at 19:20
  • As you can see in the question, I have modified the question to show the debt-to-EBITDA ratio and debt-to-net-income ratio. Both are quite difference. It confuses me even more. What are your thoughts about it?
    – J.Doe
    Sep 21, 2022 at 14:08

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