Series: Finance 101

A house worth a million with a nine hundred thousand mortgage is a very different deal from the same house with no mortgage at all. Companies work the same way. Debt-to-equity tells you how mortgaged the business is.

The math is simple. Take what the company has borrowed and divide by what the owners have put in. The plain question is this. For every dollar the owners have in the business, how many dollars do lenders have at risk?

Debt itself is not evil. A loan that builds a factory which earns more than the interest costs is good business. The danger is a bad year. Lenders must be paid even when customers stop coming. That is why cautious readers start asking hard questions when the ratio climbs well above 2 for ordinary companies. Heavy industries run higher by design, so always compare a company with its own kind.

Two companions complete the picture. Net debt is total debt minus ready cash. It respects the cash sitting in the safe. Interest coverage asks how many times the operating profit covers the interest bill. Above 5 is comfortable for most businesses. Below 1 means the business does not earn enough to pay its lenders.

Pocket rule: Before asking whether a company can grow, ask whether it can survive a bad year.

A share price is just a number until you know what it buys. That is the job of the P/E ratio.

It is the share price divided by the earnings per share. It answers one plain question. How many dollars am I paying for each dollar of yearly profit?

A P/E of 20 means you pay twenty dollars for one dollar of annual earnings. The market usually pays a high multiple when it expects fast growth. It pays a low multiple when a business looks cheap or when trouble is brewing. The same low number can mean either, so the ratio starts the question. It does not answer it.

Now the blind spots. The P/E ratio ignores debt completely. A company can look cheap on P/E while its borrowings quietly grow behind the curtain. The ratio also breaks when earnings are tiny or negative, because dividing by almost nothing makes the math meaningless. And always check which earnings a site is using. The last twelve months and next year’s estimates can paint very different pictures.

So read it next to the debt line from next week’s post and the cash trail from the last two. A price tag tells you what the seller asks. It never tells you what the thing is worth.

Pocket rule: A price tag without the debt is not the full price.

Cash flow and free cash flow sound like the same thing. They are not. And the difference matters.

Start with cash flow. Picture a lemonade stand. You sell $100 of lemonade. But $60 of that is IOUs from customers who will pay next week. Your cash flow counts only the $40 actually in the jar, minus what you paid for lemons, sugar, and cups. It’s the real money that moved.

Now free cash flow. Your stand also needs tools like the juicer, the table, and the cooler. Those cost money. Without them there’s no lemonade tomorrow. Capex is the cash spent on those long-term tools. Free cash flow is what’s left after you pay for running the business and keeping the tools in shape. Operating cash flow minus capex.

Why does this matter? Everything a company actually does with money is paid in cash, never in accounting profit. It pays lenders, pays dividends, buys back shares, and builds the next factory. Profit can be dressed up with one-time tricks. Cash cannot. A company can report profit and still go broke if the cash never arrives. And a company can report losses for years and be perfectly healthy if the cash keeps coming.

Jeff Bezos bet Amazon on this in 1997. In his first letter to shareholders he wrote that when forced to choose between making the accounting look good and maximizing future cash flows, he would take the cash flows. He reprinted that letter every year. For two decades Wall Street mocked Amazon’s tiny profits. Meanwhile the cash kept coming, and the company kept building.

Pocket rule: cash flow tells you what arrived. Free cash flow tells you what stayed.

Read Bezos’s 1997 letter

Revenue is the least honest number in finance. Ask this instead. After the sale, what’s actually left?

Revenue is the total value of everything a company sold. That’s the top line. But selling a lot means nothing if it costs even more to sell it. A company can sell a billion dollars and still lose money.

Gross profit is what’s left after the direct cost of making the thing. That means the lemons and the sugar, not the rent. Software often keeps 70 cents of every dollar. Supermarkets may keep only 25. Both can be fine businesses. It depends on the volume.

Operating income is what survives salaries, rent, marketing, and research. It shows whether the core business actually works. Net income is the famous bottom line. It comes after interest and taxes. It’s real. But it’s also the easiest number to fudge with one-time tricks.

Revenue tells you how big the machine is. Profit tells you whether the machine works. Always read both.

every house has three prices. so does every company.

Price one: $500,000 — the listing. That’s the market cap: what the crowd will pay for the shares today.

Price two: $670,000 — the true cost. The listing, plus the $200,000 mortgage you’d inherit, minus the $30,000 cash in the safe. That’s the enterprise value: what you’d really pay for the whole thing.

Price three: $200,000 — the ledger. You bought the place years ago for $400,000 and still owe $200,000. That’s the book value: what the accountant’s records say your stake is worth.

Market cap is the crowd’s price. Enterprise value is the buyer’s price. Book value is the accountant’s price. Three honest answers — just don’t mix them up.

the share price tells you what the stock costs. the enterprise value tells you what the company costs. never confuse the two.

A house listed at $500,000 — that’s the market cap, the price of all the shares.

It comes with a $200,000 mortgage you’d take over — that’s the company’s debt. Add it.

There’s $30,000 cash in a safe inside — that’s the company’s cash. Subtract it; it comes to you.

$500k + $200k − $30k = $670,000. That’s the enterprise value: market cap plus debt minus cash. What the whole company really costs.