Buthowmuchdebtistoomuch?

Andwhatshouldinvestorswatchoutfor?

Whendebtmakessense

Itoftenmakessenseforafirmtoborrowmoney,ratherthanraiseitinalternativeways,becauseit’scheap。

Takeyourownfinances。

Theinterestrateonyourmortgageisgenerallyalotlowerthantherateonyourcreditcard。

Why?

Becausethemortgageissecureddebt。

Ifyoudon’tpayit,thebankcantakeyourhouse。

Ifyoufailtorepayyourcreditcard,thebankdoesn’thaveanyassetstofallbackon。

It’sthesameprincipleforcompanies。

Asafirm,youcanofferalendersecurityintheformofassets,suchasproperty。

Also,bylaw,lendersarefirstintherepaymentqueue。

Interestonbankloansmustbepaidbeforedividendscanbedishedouttoshareholders。

Andifacompanygoesbust,lendersgetrepaidbeforeshareholderscan?

stakeaclaimtoanyleftoverassets。

Thesetwofactorsincreasesecurityforalender,whichmakesthecostofborrowinglowerthanthecostofraisingmoneyfromshareholders(byissuingmoreshares)。

Butthere’sanotheradvantagetoo,whichcanbegoodnewsforshareholders–thegearingeffect。

Howdebthelpsshareholders

Let’stakeaverysimplescenarioinvolvingtwofirms。

Eachhasbalancesheetnetassetsof£100m。

Thefirstfirmis100%fundedbyshareholderequity–soshareholdersinvestedthisfull£100m。

Thesecondis50%fundedbyequityand50%debt(carryinganinterestrateof10%)。

Soshareholdersinvested£50m,while£50misaloanfromthebank。

Let’ssaybothfirmshaveaverygoodyearandmakeenoughprofittoboosttheirnetassetsby£50m。

Soeachfirmnowhasnetassetsof£150m(£100m+£50m)。

Now,let’ssaythetwofirmsareliquidated(soldoffforthevalueoftheirbalancesheets)immediately。

Withthefirstfirm,shareholderswhostartedwith£100mofequitywillwalkawaywith£150m。

That’saniceprofitof£50m,or50%(£50m/£100mx100%)。

Butit’sevenbetteratthesecondfirm。

Ithasnetassetsof£150m。

Afteritisliquidated,itpaysbackthe£50mdebtand£5mofaccruedinterest(£50mx10%)。

Thatleavesitwith£95m。

Butitsshareholdersonlyinvested£50m。

Sotheyvemadea90%return–theyvealmostdoubledtheirmoney。

Howitcanallgowrong

Thisexampleshowshowusingdebtcanboostyourreturnsifthingsgowell。

Troubleis,itworksinreversetoo。

Saythere’sarecession,andnetassets,whichstartedat£100m,shrinkto£50m。

Thefirstfirm’sshareholdersnowhavenetassetsofjust£50m,whentheyhadinvested£100m?

Theyaredown50%。

Buttheyarestillbetteroffthanshareholdersinthesecondfirm。

Ifthatfirm’sassetsarereducedto£50mthat’sonlyenoughtopaybacktheoutstandingdebtof£50m。

Afterthatthereisnothingleft。

Soshareholderslose100%oftheequitytheyhadinvestedayearago。

Themessageissimple:debtcanboostyourreturns,butitalsomagnifieslossesinbadyears。

Thismeansthatthemoredebtafirmcarries,ortousethetechnicaltermthehigheritsgearing(theamountofdebtitcarriesrelativetoequityfunding),theriskieritisas?

aninvestment。

That’sbecausehighgearingmeansthatearningsfigureswillbemorevolatile。

Thatusuallymeansamorevolatilesharepricetoo。

Whichsectorstendtocarrylotsofdebt?

Intheoryanyfirmcantakeondebt,butsomearemorelikelytothanothers。

Theanswerdependsonmanyfactors。

However,probablythemostimportantiscashflow,andhowthismatchesuptoacompany’splannedrateofexpansion。

Forexample,foodretailerslikeTescooftendon’ttakeonlotsofdebttoopennewshops,astheyalreadygeneratelotsofcashfromcustomers。

Telecomsfirms,ontheotherhand,needtobuildlotsofexpensiveinfrastructurebeforetheycanmakeanymoney。

Thatoftenmeanstakingonlotsofdebt,especiallyiftheyareracingtograbmarketshareinnewcountries。

Constructionfirmsarealsooftenheavilyindebtedastheyneedtoinvestinbuildingsalongtimebeforetheyreceivecashfromsales。

Inotherwords,whatmightbeahighlevelofdebtinonesectormightbeperfectlynormalinanother。

Sothekeytoassessingwhetherafirmiscarryingtoomuchdebt,istocompareitsgearinglevelstothesectoraverage。

Youalsoneedtojudgehowstrongitscashgenerationis–canitkeepgettingcashinfromcustomers?

Ifitdoesn’thavecashcominginthedoorsteadily,itwon’tbeabletopayinterestonitsdebts。

Howtotestfordebtdistress

Ausefulratioforlookingatdebtis‘interestcover’。

Youcancalculateityourselforpickituponmostinvestmentwebsites。

Ineffect,itlooksathowmanytimesoverthefirmcouldcoveritsinterestbillwithitsprofits。

It’sabitlikeyoucomparingyournetsalaryeachmonthtoyourmonthlymortgageinterestbill。

Themoretimestheformercoversthelatter,thebetter。

Soifafirmgeneratesprofitbeforetaxof£100m,andhasaninterestchargeof£50m,interestcoveristwotimes(£100m/£50m)。

Thehigherthebetter。

Forme,twoistheabsoluteminimumsafetylevel。

I’dratherseethreeorfourtimes,butthenIamfairlycautious。

Bycomparison,atriple-Acreditrating,thehighestavailablefromaratingsagency,usuallyrequiresafirmtohavecoverof?

tentimesormore(andofcoursemeetlotsofothercriteria)。

Ofcourse,thisisn’ttheonlymeasureyoushouldbelookingatifyou’rethinkingofinvestinginacompany。

We’verunthroughseveralothersinthisseriesalready。

Butitwillgiveyouagoodideaofjusthowfinanciallysecureacompanyis。

Andinthecurrentunforgivingenvironment,that’sanabsolutelyvitalpieceofdatatocheckbeforeyouinvestinanything。

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