QUALIPORT
Do Your Shares Have Too Much Debt?

By Maynard Paton (TMFMayn)
June 16, 2003

A common concern expressed by most novice investors is the use of debt by their chosen company. Just how can private investors spot those firms with dangerous levels of borrowing? Today's Qualiport will review the increased investment risk that debt brings and how to spot any impending trouble.

Why do companies borrow money?

Let's start at the beginning. Why do companies borrow money? Essentially, just as long as the money borrowed from the bank can generate a return in excess of the interest payments, the company's equity shareholders will benefit.

Imagine two companies, A and B. A is funded by 4,000 £1 ordinary shares, while B is funded by 2,000 £1 ordinary shares and £2,000 of debt. Interest on B's debt is 10% per annum. The advantage for ordinary shareholders of their company substituting equity for debt is shown in the table below:

                    Company A     Company B
                        (£)          (£)

Equity                 4,000        2,000
Borrowings                 0        2,000

Operating Profit       1,000        1,000
Interest                   0         (200)
Pre-tax profit         1,000          800
Tax (30%)                300          240
Earnings                 700          560

Earnings per share      17.5p        28.0p

Return on Equity        17.5%        28.0%

Although the inclusion of an interest charge causes B's overall earnings to be lower than A's, those earnings are divided across fewer shares and a smaller equity base. Thus B's earnings per share and return on equity are superior to A's, all to the greater benefit of B's shareholders.

Volatility

But the utilisation of debt works both ways. Suppose both A and B suffer a downturn in their respective businesses:

                    Company A     Company B
                        (£)          (£)

Equity                 4,000        2,000
Borrowings                 0        2,000

Operating Profit         200          200
Interest                   0         (200)
Pre-tax profit           200            0
Tax (30%)                 60            0
Earnings                 120            0

Earnings per share       3.5p           0p

Return on Equity         3.5%           0%

This second table highlights a key factor for companies with debt: the increased volatility of their earnings. So although B may have greater earnings during buoyant trading conditions, it has the potential for greater losses during a more difficult climate.

But not only is B's earnings stream more sensitive to differing trading environments, there's also an obvious sensitivity to interest rate movements. Imagine that, for whatever reason, B's lenders now increase their interest rate to 11%.

                     Company A     Company B
                        (£)          (£)

Equity                 4,000        2,000
Borrowings                 0        2,000

Operating Profit         200          200
Interest                   0         (220)
Pre-tax profit           200          (20)
Tax (30%)                 60            0
Earnings                  120         (20)

Earnings per share       3.5p          (1)p

Return on Equity         3.5%          n/a

Overall, the increased earnings volatility from variable trading conditions and interest movements gives B greater potential to slip into the red. And it's the enhanced danger of losses that highlight the main risks of borrowing -- that of coming under the undue attention of the lenders.

It must be noted that:

* While dividend payments due for equity shareholders can be reduced or skipped at the company's discretion, there's no such flexibility for interest payments, and;

* Unlike shareholders' equity, which is only repayable on the company's liquidation, borrowings do have to be repaid at some point.

Needless to say, trouble with interest payments and repaying loans doesn't do a share price any favours.

Overall, while the use of debt can lead to greater company profitability, it also increases the investment risks for investors. In my view, one offsets the other. However, with the investment maxim minimise the downside in mind, I'd always prefer to be invested in a company possessing a large cash pile and producing average profitability rather than one generating great shareholder returns through excessive borrowing.

How much is "too much debt"?

So, how do you measure a company's borrowings to ensure its bank manager won't be paying an untimely visit? Unfortunately, there are no strict guidelines. There's no magic formula to inform you of "too much debt".

Instead, consideration for the company's business comes first. The "profit predictability" of the business counts for a lot when reviewing its debt situation. For example, what may seem a comfortable amount of debt for a water company could appear far too onerous for a toy company.

Coupled with business considerations, a visit to the accounts will help form an initial opinion on debt levels. Then apply another investment maxim -- "if in doubt, stay out" -- to create the overall investment decision.

Gearing

The traditional way of measuring debt is through the gearing (or the debt to equity) ratio, expressing the company's debt as a percentage of its equity base or capital employed. Essentially, the higher the percentage, the greater the debt worry.

               Total debt
Gearing = ------------------- (%)
          Shareholders' Funds

                            Total debt
   Or   = --------------------------------------------------- (%)
          Shareholders' Funds + Total Debt (Capital Employed)

To derive a figure for "total debt", a company's accounting notes must be inspected. Contained within both creditor notes (amounts falling due within one year and amounts falling due after one year) will be the company's outstanding debt.

However, there are two main flaws with the above gearing calculations and any other similar equity-based "debt" ratio:

* It penalises companies with asset-light businesses, and;

* It doesn't inform how easily the company will service the interest payments of that debt. A company may have a "low" gearing percentage, but it (hopefully) won't pay off its lenders by disposing of its assets (reflected by shareholders' funds).

Interest cover

Using the company's profit and loss account, a far better measure of debt level is the interest cover calculation. The higher the cover is, the better. Low single digit interest cover calculations point to possible future bank manager trouble. And apart from addressing the above interpretation problems of gearing, interest cover also does away with any interference from balance sheet window dressing that gearing calculations sometimes fall victim to.

But again, there are variations on a theme:

                        Operating Profit + Interest Receivable
Gross Interest Cover =  --------------------------------------
                                    Interest Payable

                      Operating Profit + Net Interest Payable
Net Interest Cover =  ---------------------------------------
                                Net Interest Payable

Gross interest cover is the more conservative calculation of the two. The net calculation can hide companies that could be heading for trouble:

                      Company C
                         (£)
 
Operating Profit         400
Interest Paid           (200)
Interest Received        220
Pre-tax Profit           420

Gross interest cover for company C would be 3.1 (£620/£200), a low figure that would set alarm bells ringing. However, net interest cover is below 0, indicating that the company could be "debt free". That's certainly not the case.

What would happen if company C suddenly spent all of its interest-receiving cash pile on a new factory that had somewhat uncertain prospects? Strip out the interest received and both interest cover calculations would produce a figure of 2, a very low cover that the original 3.1 gross interest figure would have warned of. For a good example or two of the dangers of low interest cover, check out the subsequent performance of the five shares high in this feature.

Other points to note

There are three other accounting points to note when considering companies with debt.

1. The actual rate of interest: Calculating the company's effective interest rate on its debt can highlight debt-related problems:

                            Interest Payable
Effective Interest Rate =  ---------------------
                           Average debt employed

The average debt employed is simply the average of the opening and closing amounts of the company's total debt from its latest financial year. Compared to normal lending rates, any out-of-the-ordinary effective interest rate should warrant further investigation. Too low a rate could indicate debt taken on towards the company's year-end, where the subsequent impact of higher interest payments will only be seen in the next financial year. Too high a rate may mean the lenders are very unsure of the company's operation, this feature on Versailles highlighting a possible example.

2. Maturity profile: Every company with debt produces a maturity profile of its borrowings within its accounts. Companies that have large loans to pay off soon may need to seek replacement funding that could possess a higher rate of interest.

3. Secured loans: Debt can be secured against a company's assets, with the lender able to take possession of the relevant assets should the company fall into arrears. An accounting note should describe whether each loan taken out by the company is secured or unsecured. Alongside a low interest cover, if most of the loans are secured, the lenders may smell trouble.

Summary

As mentioned earlier, there are no definite guidelines to judging whether a company has "too much debt". The predictability of the business and gross interest cover are the key factors to base any decision, with the company's effective interest rate, debt maturity profile and use of secured loans adding to the picture.

Overall though, debt increases the investment risk. Its use creates additional earnings volatility and uncertainty, not enticing characteristics of a long-term investment. Indeed, rather than judge a company's level of debt, investors would do well to concentrate on those businesses that have no need for borrowings. The best companies for the long-term have always operated without recourse to moneylenders. Instead, they've always sat upon ever-growing cash mountains.

This article was first published in January 2001.