Too much debt can kill an otherwise healthy business.
Spend any time monitoring company results, and you quickly get a feel for the headline numbers that companies like to lead with. Sales up! Profits up! Earnings per share up! Order book up!
Of course, the news isn't always that positive, and sometimes the numbers are down. Or positive, but by not as much as expected. This week, for instance, we've seen a bit of both -- Royal Dutch Shell (LSE: RDSB) reported profits down 75%, while BP (LSE: BP) disappointed a couple of days earlier.
But it's easy to read too much into these headline figures. Year-on-year, they can change quite radically, and still not affect the core investment proposition. Despite their iffy results, for instance, both BP and Shell continue to pay an unaffected dividend. Neither is heading for the knacker's yard any time soon.
Hidden bombshell
Yet peer further down the accounts, past the headline numbers and the chairman's waffly flannel, and you'll spot some information that is far more critical. There's a number that can kill a company, and which can send its share price crashing southwards.
I'm speaking of debt, of course. In the final analysis, what generally kills a business isn't a shortfall in sales or profits. Quite significant fluctuations in these can often be weathered with impunity. But too much debt is a bullet waiting to be fired.
Yet perhaps surprisingly, 'too much' is something of a nebulous concept. In short, 'too much' -- compared to what?
Interest cover
One immediate red flag is when debt appears to be too much compared to a business's ability to service that debt.
Greene King (LSE: GNK), for example, earns decent operating profits from its clutch of beer brands, pubs and restaurants -- but sees a whopping 40% of that profit immediately soaked up by interest payments. You don't have to be Einstein to envisage a situation where a poor set of results would see an even bigger share of the business's earnings go to reward banks, rather than shareholders.
So in looking at company accounts, I always scroll down to the amount of debt, and the amount of interest paid on that debt. I continue to think that Greene King is a decent business -- but I'd dearly love to see its mountain of debt reduced more quickly.
Banking facilities
'Too much debt' can also be considered in terms of the amount of credit that bankers are willing to extend. Because when they won't extend any more credit, then it's time to call in the receivers.
It was breached banking covenants that eventually saw outdoor clothing retailer Blacks Leisure (LSE: BSLA) forced into a drastic restructuring at the end of 2009, for instance. When banks won't lend any more, shareholders almost invariably suffer.
How to tell? It's not a line in the accounts, but rather a few words in the accompanying text that give the game away. If there's significant net debt, and a business says it is 'comfortably within its existing banking facilities', or talks about 'adequate headroom', that's good news -- of a sort. But debt can mount quickly, and words like 'adequate' and 'comfortably' at the very least merit a little deeper investigation.
Short term vs. Long term
'Too much debt' can also be a question of timing. Banking facilities aren't an undated blank cheque: they're commitment by a bank to lend up to a given amount, until a certain date. After which, the bank may reduce or withdraw the facilities altogether -- potentially leaving the business with inadequate working capital and cash.
So if a business's banking facilities are due for review any time soon, then a business that's trading healthily has a much better chance of seeing its facilities renewed on favourable terms -- or even renewed at all -- compared to one that isn't doing so well.
As the credit crunch hit, for example, and banks started to be cagey about who they would lend to, companies such as Punch Taverns (LSE: PUB) found themselves seriously embarrassed. When it last reported its results, Punch spoke of successfully reducing debt by a £1 billion -- a useful step in the right direction, but one that even so still leaves the company exposed.
Gearing
Finally, debt can be considered 'too much' in relation to shareholder equity -- gearing, in other words. It's often reported as a pre-calculated ratio, although it's worth double-checking the figures if looking at an on-line data source rather than the company's own accounts.
Some gearing is good, as it finances growth without diluting shareholder's funds. But a business that is very highly geared is potentially a business that just has too much debt -- leading to the sort of difficulties outlined above.
And one thing is certain: the more highly geared a business, the more exposed it is to interest rate rises. As the economy picks up, interest rates will rise -- and it's those highly-geared businesses that will suffer first, and suffer worst.
Even so, it pays to peer past the raw ratio. Tesco (LSE: TSCO) is for example far more highly geared than either Sainsbury (LSE: SBRY) or Morrison (LSE: MRW). I'm not too concerned, though. First, a good chunk of this debt is in the form of fixed-interest corporate bonds, rather than money owed to banks -- and second, I don't think Tesco is in any immediate danger of not being able to service its debt!
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Malcolm owns shares in Tesco and BP.
