‘I am living so far beyond my income that we may almost be said to be living apart’.

        E. E. Cummings – American Poet 

Everyone seems to know someone who cannot live within their means and many businesses can be run in that way.

When buying shares it can be a good idea to consider how well the business lives within its means, and preferably below it. This article explores this idea.

1.     Debt Is Bad

Some debt is unavoidable in life and many people have mortgages and loans, but it’s the balance of those debts to income, or the capacity of the business to service the debts, that matters.

Relatively small and manageable amounts of debt provide a business with flexibility to cope with financial headwinds, so if credit dries up or cash flow is experiencing a temporary shortfall the business is still able to meet its mandatory fixed costs and debt obligations. If the business is using a relatively large proportion of its income to service debts, it has less flexibility in times of adversity and is therefore more vulnerable.

Consider the level of gearing (debt) in any business and assess it within the context of a range of measures that will support your assessment of how manageable the debt is in a range of future scenarios. Remember that debt may be manageable in good times, but how manageable might they be in bad times?

During the current recession many businesses found themselves in severe difficulty due to the levels of debt they were servicing whilst not having access to adequate cash reserves. This is like finding yourself in a restaurant that doesn’t take cards when you don’t have the cash to pay the bill.

2.     Money Is Good

Does the business have enough money to provide a buffer zone in hard times? How does the business spend its money and what is the return on that money?

Has the business been spending money like a teenager with their parents credit card or has it demonstrated prudent financial management?

3.     Live Below Your Means

A smart business will not just live within its means, but well below it. Some of the most successful people in the world do the same. Look at one of the world’s richest men, Warren Buffet. A billionaire with a modest lifestyle living in the same house he purchased nearly 50 years ago for just over $30,000.

Carlos Slim from Mexico is currently the world’s richest man with more money than Bill Gates and is said to have lived in the same house for more than 40 years and once again is said to have simple tastes.

The intelligent investor should aim to find the business equivalent of Carlos Slim or Warren Buffet. Start by targeting companies that can live below their means and take it from there.

Jamie E Smith is the author of the book Making Money From Stocks And Shares

This content was provided by one of our users, Jamie