## Sunday, 16 July 2017

### Measuring a company's debt

There are lots of ratios which can be used to explain a company's debt position.

For most investors the following four will tell what they need to know:

1. Debt to free cash flow.
2. Debt to net operating cash flow.
3. Debt to assets.
4. Interest cover.
These ratios only deal with debt shown on a company's balance sheet.

Investors must also be aware and be able to deal with hidden, or off-balance sheet, debts too.

1.  Debt to free cash flow

Debt to free cash flow tells you how many years it would take to repay all a company's debt with the current rate of free cash flow it is producing.

The lower the number, the better, as a lower number means that a company can repay its debt quickly.

You should rarely look at a company with a debt to free cash flow ratio that has been consistently more than 10.

Debt to free cash flow is calculated as follows:

debt to free cash flow = total borrowings / free cash flow

This ratio can give a high number for two reasons:
• high debt or
• low free cash flow.

It will give a negative number if a company has negative free cash flow.

Like all ratios, it is best looked at over a number of years to see if it is normal for a company to have a high value or it it is a recent trend.

Companies with low debt to free cash flow have enough free cash flow to pay off all their borrowings in a matter of months.

Property, pubs and utility companies normally have high levels of debt as they are deemed to have sufficiently stable cash flows to support it.

Example:

Company X would take 200 years to repay its debts based on its current free cash flows.

Debt to free cash flow = 200.

This is not normal given its recent history.

This would suggest that you need to investigate what is going on.
• Has debt surged?
• Has free cash flow plummeted?
• Does the management have a plan to reduced debt and increase free cash flow?

2.  Debt to net operating cash flow

Net operating cash flow is the amount of cash a company has from trading after it has paid its taxes.

By comparing this number with the total amount of debt, you can see how long it would take the company to pay back the debt if it stopped investing in its assets.

The lower the number, the better.

It is calculated as follows:

debt to net operating cash flow = total borrowings / net operating cash flow

This is the worst-case scenario test.

This ratio assumes the company spends nothing at all on maintaining its assets for a period of time.

This only happen for a couple of years for most companies before their assets become worn out and lose their ability to make money.

Therefore, with most companies, you want to see a debt to net operating cash flow ratio of less than 3.

Value for this ratio of over 5, indicates companies with significant amounts of debt relative to their cash flows.

Companies with poor profits and cash flows have high debt to net operating cash flow and have increased financial risk.

3.  Debt to assets

Debt to assets tells what percentage of a company's assets is taken up by debt.

The higher the percentage, the more risky a company generally is.

It is calculated as follows:

debt to assets = total borrowings / total assets

Generally speaking, avoid companies where the debt to total assets ratio is more than 50%.

This is one of the reasons why shares of banks can be extremely risky, as debt to assets ratios are over 90% in 2016.

Company with a very low percentage of debt to its total assets is a good sign.

4.  Interest cover

Interest cover is not a measure of debt, but a measure of how many times a company's annual trading profits (EBIT) can pay the interest on its debt.

The higher the number, the safer the company is.

Interest cover is calculated as follows:

interest cover = EBIT / interest payable

Look for a figure of at least five times, however, prefer to invest in companies where the ratio is 10 or more.

Danger zone is when the interest cover falls to 3 or less.

Excluding utility companies and property companies which have high levels of debt - and therefore low interest cover - a figure of 5 means that profits can fall by at least 40% before the ratio starts getting into the danger zone of interest cover of 3 or less.

Summary:

For most investors the following four will tell what they need to know:

1.  Debt to free cash flow.
Avoid if Ratio > 10
Good if Ratio < 10
Lower the better

2.  Debt to net operating cash flow.
Avoid if Ratio > 5
Good if Ratio < 3
Lower the better

3.  Debt to assets.
Avoid if Ratio > 50%
Good if Ratio < 50%
Lower the better

4.  Interest cover.
Avoid if <3:1 div="">
Good if > 5:1
Higher the better