DEBTS are often neglected in company analysis and valuations. Red flags.

Look out for companies that report consistent profits but also a substantial rise in gearing, which would indicate negative FCF.  

Receivables and/or inventories rise even faster than increasing sales

This is usually the case when companies report increasing sales but where receivables and/or inventories rise even faster.

If a company's receivables grow at a much faster rate than revenue, it will suffer net cash outflows, which have to be funded with increasing debt (or cash calls).  It can continue to report steady profits for many years - even as the company is being crushed by mounting debt and interest expenses.   Investors who are fixated on earnings would not realise the looming issue until it is too late.

Paying dividends in excess of cash flow from operations

Companies that pay dividends in excess of cash flow from operations may also warrant a red flag.  

This is the danger when management's interest are not always aligned with that of shareholders.  The fact is that management remuneration/incentives are usually based on profitability and share price gains, which encourages short-termism and risk-taking, including using leverage to boost earnings.  Anecdotal evidence shows that high dividends/share buybacks tend to lead to higher share prices.

Indeed, sometimes not all shareholder's interests align either.  Some are short term, preferring dividends/share buybacks while longer-term-minded investors would prefer companies to conserve cash for future opportunities and/or pay down their debts.

Borrowing to invest in productive assets

Companies necessarily reinvest for the future, funded with internally generated funds and/or borrowings and equity cash calls.  Borrowing to invest in productive assets that will generate future cash flows is perfectly fine - as long as the increased risks that come with it are understood and properly taken into consideration.

Company with less debts is less risky and better positioned

Company that pay off its debts would be better positioned to withstand any unexpected economic and financial shocks - thereby making it the safer investment.  It would be better able to capitalise on future opportunities - for example, mergers and acquisitions, relative to its competitors which large debts, thanks to its stronger balance sheet.

Conclusions

There will always exist a trade-off between risks and rewards.  It is important to analyse both aspects in tandem.  

There is nothing wrong if you choose to go for the higher returns, provided you also understand the risks and can stomach the potential losses.  

Some investors are risk takers, others are more risk-averse, but the smartest investors make informed decisions.

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.

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

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business