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How much debt is too much?

This article appeared in the April 2014 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Seven factors to consider if the balance sheet is strong - or an investment landmine.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

When investing in a company there are two important things to look for: you do not want the company to go broke, and you want it to return more than you invested. Both of these outcomes are influenced by how much debt a company carries on its balance sheet. So how can you tell when a company has too much debt?

Companies typically fund their operations by a mix of debt and equity. It's a bit like home ownership. If you have a mortgage, the bank is funding part of the house (debt) and you are funding the rest (equity).

But that's where the analogy ends, because unlike a nasty mortgage, business debt is not always a bad thing. Used prudently it can boost a company's return on equity (ROE) - the return shareholders receive on their part of the funding equation - because debt is typically a cheaper form of funding than money supplied by shareholders (equity).

It is important that management gets the debt/equity mix right. Too much debt can place a company in jeopardy when business conditions go sour, because, unlike shareholders, lenders demand to be paid in bad times as well as good.

Mixing debt and equity

What is the optimal mix of debt and equity? Investment guru Ben Graham used to say that a company should own more than it owes. A simplification but a good starting point.

A commonly used metric used to measure the mix that Graham is talking about is called the debt-to-equity ratio. It quantifies the relative proportion of debt and equity used to fund a company's operations.

A refinement of the ratio uses net debt instead of total debt. Net debt is calculated by deducting the cash held by the company from its total debt. It is a useful adjustment, particularly for companies holding significant cash deposits.

Net Debt/Equity ratio = Financial Debt - Cash 
                                                   Equity

Relating this back to Graham's rule of thumb, that a company should "own more than it owes", this is the case when the net debt-to equity ratio is below 1. It can also be expressed as a percentage, in which case you would be looking for a figure below 100 per cent.

Another way to express this relationship is the percentage of total assets funded by debt. For example, if the net debt/equity ratio is 1, it would be expressed (using the formula below) as net debt represents 50 per cent of total capital.

Gearing =      Net Debt    x 100
                    Net Debt+Equity

Don't forget leases

Many leases are just a quasi form of debt. This is particularly so with finance leases where the lessee enjoys the benefits and assumes all the risk of the property, plant or equipment. So when calculating gearing ratios it is appropriate to include them as debt.

Some analysts also like to include some off-balance-sheet liabilities in the calculation. Examples include operating leases and unpaid pensions, particularly when they are substantial.

Analysing the debt-to-equity ratio

Contrary to Graham's declaration that it is OK when a company owns more than it owes, it is a simplification. What constitutes an acceptable level of debt varies from company to company; its determination is a mix of analysis and judgement. Here are some important factors to consider.

1. Volatile revenue stream

Lenders demand that interest and principal payments are made on time and in full. But when a firm has a volatile revenue stream, its ability to meet these regular payments is less certain. The problem is compounded when a business is burdened with high fixed costs - the costs of simply keeping the doors open even if it is not doing any business. Look out for red flags, such as where a company's debt materially exceeds that of its industry peers.

2. Concentration risk

When a large portion of the company's business is limited to a few customers, it is prudent for it to carry less debt. Loss of an important customer will hurt its revenue stream and jeopardise its capacity to service debt.

3. Start-ups and young companies

New companies with a limited track record should carry less debt. Their business models have yet to be fully tested and the reliability of their future revenue stream is often difficult to judge.

4. Debt structure (debt maturity)

The mix of long and short-term debt employed by a company is important. Long-term assets should preferably be funded out of equity and long-term borrowings, while working capital needs are best funded by bank overdraft and short-term borrowings.

Watch out for companies that rely heavily on the use of short-term debt, particularly those with a poor credit rating. These companies are faced with an ever-present need to keep rolling the debt over, and failure to do so could lead to business future.

Maturities of borrowings should also be well spread. If the bulk of a company's borrowings fall due at a time when the availability of funds is limited, such as the recent post-GFC period, refinancing may prove difficult. With a chronological spread of maturities, the need to approach the capital markets for a large refinancing in a depressed period is reduced.

5. Debt structure (currency of debt)

Check the currency of the debt. A company with overseas assets and/or revenue will often reduce its currency exposure by maintaining a similar level of debt in that currency. If this is not the case, offshore borrowing is still OK if it is largely hedged/swapped back to Australian dollars. If neither is the case, the company is probably exposed to the risk of currency fluctuations.

6. Look out for loan covenants

A loan covenant is a clause in the lending contract requiring the borrower to refrain from doing certain things. For example, the borrower might have to maintain the ratio of total liabilities (borrowings and other liabilities) to total tangible assets at a certain percentage, say no higher than 60 per cent.

It is very important that companies maintain such ratios. Even if a company is servicing its debt, the breach of such a covenant may lead to a "technical breach" of the contract and potential recovery action by the lender.

7. The level of secured borrowings in a company's balance sheet

Check the level of security that lenders are demanding. Where risks are high, lenders tend to demand more security. This provides an indication of the risk they have attached to that company.

Augment your analysis with other financial ratios

The debt-to-equity ratio should not be relied upon to the exclusion of others. Many other metrics can be used to judge the appropriateness of a company's debt. One commonly used is the interest cover ratio, which shows how comfortably a company can meet its interest payments.

Interest Coverage Ratio =   EBIT
                                        Interest Expense

EBIT is profit from ordinary activities before interest expense and income tax.

The higher the ratio the better. But the ratio should be interpreted in a similar fashion to the debt-to-equity ratio. What represents an acceptable figure depends on a number of factors, including the nature of the company's business, the volatility of its revenues and the composition of its debt. However, as a guide, when an interest coverage ratio falls below 2, concern should be raised.

The balance sheet is just a snapshot in time

A criticism of the ratio approach is that ratios are static. They are correct at just one point in time (balance date). Yet we are applying them to businesses that are dynamic - the economic factors affecting businesses are always changing.

Undertaking a debt capacity analysis goes some way towards addressing this issue. It poses a series of "what if" questions.

Take, for example, a company such as Fortescue Metals. A debt capacity analysis seeks to quantify the effect on its ability to service debt under a variety of different scenarios. For example, what would happen if:

  • The price of iron ore dropped 50 per cent
  • Interest rates rose by 3 per cent
  • The Australian dollar appreciated by 20 per cent
  • Fortescue's capacity to raise new equity was shut down.

Purchasing shares on margin

I will finish on a very important point. In an ideal world a company's debt structure should represent the optimal balance between risk and return for that company.

What if investors choose to buy the company's shares on margin (with borrowed money)? They are effectively throwing the whole risk/reward debt optimisation issue out the window; denying the judgement of the company's directors and re-establishing their own gearing level. In the process, dialling up the risks substantially.

That is food for thought when you are next tempted to take out that margin loan.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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