FOOL SCHOOL
Deciphering Company Debt - Part I

September 5, 2005

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?

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	140	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	140	(20)
Earnings per share	3.5p	(1.0p)
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.

In Part II we look at other factors to consider such as gearing and interest cover.