FOOL SCHOOL
In Part I we looked at some of the effects debt can have on company profits. Here we look at some of the ways you can evaluate how much debt a company has. Gearing The traditional way of measuring debt is through the gearing (or the debt to equity) ratio, which expresses the company's debt as a percentage of its equity base or capital employed. Essentially, the higher the percentage, the greater the debt worry. Two definitions of gearing are generally considered acceptable. Obviously, when comparing gearing levels across different companies, you need to use the same definition to make sure you are comparing like with like. To derive a figure for 'total debt', a company's accounting notes must be inspected. Contained with 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: 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: Gross interest cover is the more conservative calculation of the two. The net calculation can hide companies that could be heading for trouble: 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. 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: Effective Interest Rate = Interest Payable / 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
Company C
£
Operating profit
400
Interest paid
(200)
Interest received
220
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Pre-tax profit
420
