Chapter 9Filter 4: Long-Term Debt to Free Cash Flow Ratio

Jacobian Inverse: I want to find businesses that, when an economic setback occurs, would have a challenging time staying competitive, let alone staying in business. After all, leverage can help magnify business results in the good times, and I would prefer to not think about what could happen in the bad times.

Extreme thinking helps me realize that I need to be mindful of a business’s balance sheet because it not a question of will an economic setback happen but when. Economic setbacks are inevitable for any business. Leverage can magnify business results for the good and for the bad. I am most concerned about planning for the bad.

Bruce Berkowitz does his best to kill a company before he buys it. It is this process that helps Bruce identify all the various economic setbacks that should they happen could the business in question survive.

“We look at companies, count the cash, and then try to kill the company,” he writes. “We spend a lot of time thinking about what could go wrong with a company . . . We try every which way to kill our best ideas. If we can’t kill it, maybe we’re on to something.”1

It’s the oldest advice in personal finance and it takes many forms: Save for a rainy day. Prepare for the worst and hope for the best. Don’t buy things you can’t afford. Live within your means.

It’s good advice, too. And not just because your father or grandmother gave it to you. It’s good advice because it reveals a fundamental ...

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