Showing posts with label debt ratio. Show all posts
Showing posts with label debt ratio. Show all posts

Sunday 16 July 2017

Using debt ratios to analyse companies

The debt measure ratios for five companies.

Name   Debt to OPCF   Debt/FCF   Interest Cover   Debt/Total Asset
A          7.8                     22.9                 1.8                 162.0%
B           0.2                      0.2             213.9                     6.7%
C           6.5                    47.9                 2.1                   43.3%
D           2.5                      4.1                 6.8                   44.3%
E           6.4                     39.1                 2.5                   58.1%


Company A
This company's debt would take nearly 23 years to pay back.  Debt/FCF = 22.9
Its profits cover its interest payments less than twice.  Interest cover = 1.8x.
This kind of situation represents a risk of going bankrupt if profits were to deteriorate.
This would be enough to put investors off buying its shares.

Company B
This company operates a chain of fast food pizza chain.
It has very low levels of debt on its balance sheet.  Debt/Total Asset = 6.7%.
It could repay all its borrowings in less than three months based on its current free cash flow - Debt/FCF = 0.2.
It has no problems paying the interest on it.  Interest cover is 213.9x.
This is a kind of company investors might want to own shares in.

Company C
This company is in the pub business.
Pub companies are frequently financed with high levels of debt.
These companies can also tend to be quite poor at producing lots of free cash flow, as they have to keep spending money to keep their pubs in good conditions. (Heavy capital expenditure).
This makes them quite risky investments for shareholders when times get tough and profits fall.
These companies are often forced to sell their assets - pubs - to repay debts.

Company E
This is a water company (utility company).
Water companies are financed with lots of debt.  Debt/Total Asset = 58.1%.
This is not usually a problem given that they have very stable and predictable profits and cash flows.
Water is not the kind of product that tends to see demand change if the economy changes.
However, if investors are building a portfolio of quality companies with high free cash flows and ROCE, then it is unlikely that they will own shares of water companies.
This is because the returns they can earn are capped by industry regulators, which means they have very low ROCE.

Company D 
This is a hotel chain company.
Its business is conservatively financed and meets investors' target debt criteria.




Sunday 18 April 2010

Measure long-term solvency and stability

Long-term solvency ratios measure the risk faced by a business from its debt burden.  Debt interest must be paid irrespective of cash generation or profits.  Consequently, the amount of profit that can be reinvested in the business or paid as dividends is diluted.  An excessive debt burden will restrict the ability of a business to raise further debt finance.


THE GEARING RATIO

Gearing (or leverage) is a measure of a business's long-term financing arrangements (or capital structure).  It is essentially the proportion of a business financed via debt compared to equity.

Gearing ratio = (Interest bearing debt - Cash) / [Equity + (Interest bearing debt - Cash)]

The ideal proportion is subject to the nature of a business and the current economic climate.  In practice many businesses have gearing levels less than 50%.  The higher the gearing, the greater the risks from dilution of earnings and sensitivity to changes in interest rates.


THE DEBT RATIO

This measures the ability of a business to meet its debts in the long term.  It is a measure of 'security' for financiers.  The ratio should certainly be less than 100% and many believe it should be less than 50%.

Debt ratio = Total debts (current and non-current liabilities) / Total assets (current and non-current assets)

The risk posed from high debt and gearing ratios can be mitigated by high interest cover.


INTEREST COVER

This measures how many times a business can pay its interest charges (or finance expenses) from its operating profit (or profit before interest and tax).  Ideally a business should be able to cover its interest at least 2 or more times.

Interest cover (times) = Operating profit (EBIT) / Finance expenses

The ability to service debt is a measure of risk to debt providers, shareholders and ultimately the business itself.


NET DEBT TO EBITDA

Although not a traditional measure of long-term solvency, the 'net debt to EBITDA' ratio has become increasingly popular with banks as a measure of gearing.  (EBITDA stands for 'earnings before interest, taxes, depreciation and amortization'.)

Net debt to EBITDA (times) =  (Interest bearing debt - Cash) / EBITDA

Banks will typically lend a business up to 5 times its earnings.  Cash generated from operations can be substituted for EBITDA.


Use gearing and debt ratios to calculate long-term risk levels.


Related posts:

Measuring Business Performance