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.

Determining the Payback Period. When are borrowings excessive?

In the balance sheet, the total liabilities exceed the total equity overwhelmingly.  What does this mean?

There are 3 possible types of scenarios when this happens:

1.  The company has excessive long term borrowings.
2.  The company has excellent business that uses very little equity and its business is funded mainly by its creditors.
3.  The low equity is due to accumulated deficit, the result from continuing losses in operations.




Let us look at scenario No. 1:  The company has excessive long term borrowings.

Companies normally borrow money from financial institutions to fund their expansion.

• This is even more prevalent in an environment where the interest rates are low.
• Some companies will also refinance their debt by taking advantage of the low interest rate so that they can enjoy some savings in the interest payable.
• Yet others will refinance their debt with a higher interest rate to extend the maturity date of the debt.

All the above make business sense, when the return on capital is higher than the cost of capital.  

But, if the business continues to suffer despite the injection of additional funds through borrowings, then the company could be in dire straits.

When are borrowings excessive?  How do you determine this?

The key is in the payback period.

Look at the amount of long-term borrowings (normally found under the heading of Non-Current Liabilities) and then the Net Profit (found in the Income Statement).

Assuming that the company can utilise ALL its Net Profits in its present financial year to pay off its long term borrowings AND the SAME Net Profit recurs every year, you have this formula:

Payback Period in years = Long Term Borrowings /Net Profit.

The resulting answer is the payback period for the long-term borrowings.

A prudent KPI for the payback period is not more than 5 years.

Yes, you can argue that the company can achieve tremendous profit growth in the next few years.  If that happens, the number of years required to pay off its debts can be reduced dramatically.  

By the same argument, what if the economy suffers and a loss is incurred?

Total Liabilities and the Debt to Shareholders' Equity ratio

TOTAL LIABILITIES AND THE DEBT TO SHAREHOLDERS' EQUITY RATIO

Balance Sheet/             Debt to Shareholders' Equity Ratio
($ in millions)
Total Current Liabilities	$13,225
Long-Term Debt	3,277
Deferred Income Tax	1,890
Minority Interest	0
Other Liabilities	3,133
> Total Liabilities	$21,525

Total liabilities is the sum of all the liabilities of the company. It is an important number that can be used to give us the debt to shareholders' equity ratio, which, with slight modification, can be used to help us identify whether or not a business has a durable competitive advantage.

The debt to shareholders' equity ratio has historically been used to help us identify whether or not a company is using debt to finance its operations or equity (which includes retained earnings).       

-  The company with a durable competitive advantage will be using its earning power to finance its operations and therefore, in theory, should show a higher level of shareholders' equity and a lower level of total liabilities. 

-  The company without a competitive advantage will be using debt to finance its operations and, therefore, should show just the opposite, a lower level of shareholders' equity and a higher level of total liabilities.

The equation is: Debt to Shareholders' Equity Ratio = Total Liabilities / Shareholders' Equity.

The problem with using the debt to equity ratio as an identifier is that the economics of companies with a durable competitive advantage are so great that they don't need a large amount of equity/retained earnings on their balance sheets to get the job done; in some cases they don't need any. Because of their great earning power they will often spend their built-up equity/retained earnings on buying back their stock, which decreases their equity/retained earnings base. That in turn increases their debt to equity ratio, often to the point that their debt to equity ratio looks like that of a mediocre business---one without a durable competitive advantage.

Moody's, a Warren favorite, is an excellent example of this phenomenon. It has such great economics working in its favor that it doesn't need to maintain any shareholders' equity. It actually spent all of its shareholders' equity on buying back its shares. It literally has negative shareholders' equity. This means that its debt to shareholders' equity ratio looks more like that of GM---a company without a durable competitive advantage and a negative net worth---than, say, that of Coca-Cola, a company with a durable competitive advantage.

However, if we add back into Moody's shareholders' equity the value of all the treasury stock that Moody has acquired through stock buybacks, then Moody's debt to equity ratio drops down to .63, in line with Coke's treasury share-adjusted ratio of .51. GM still has a negative net worth, even with the addition of the value of its treasury shares, which are nonexistent because GM doesn't have the money to buy back its shares.

It is easy to see the contrast between companies with a durable competitive advantage and those without it when we look at the treasury share-adjusted debt to shareholders' equity ratio. Durable competitive advantage holder Procter & Gamble has an adjusted ratio of .71; Wrigley, meanwhile, has a ratio of .68---which means that for every dollar of shareholders' equity Wrigley has, it also has 68 cents in debt. Contrast P&G and Wrigley with Goodyear Tire, which has an adjusted ratio of 4.35, or Ford, which has an adjusted ratio of 38.0. This means that for every dollar of shareholders' equity that Ford has, it also has $38 in debt---which equates to $7.2 billion in shareholders' equity and $275 billion in debt.

With financial institutions like banks, the ratios, on average, tend to be much higher than those of their manufacturing cousins. Banks borrow tremendous amounts of money and then loan it all back out, making money on the spread between what they paid for the money and what they can loan it out for. This leads to an enormous amount of liabilities, which are offset by a tremendous amount of assets. On average, the big American money center banks have $10 in liabilities for every dollar of shareholders' equity they keep on their books. This is what Warren means when he says that banks are highly leveraged operations. There are exceptions though and one of them is M&T Bank, a longtime Warren favorite. M&T has a ratio of 7.7, which is reflective of its management's more conservative lending practices.

The simple rule here is that, unless we are looking at a financial institution, any time we see an adjusted debt to shareholders' equity ratio below .80 (the lower the better), there is a good chance that the company in question has the coveted durable competitive advantage we are looking for.

And finding what one is looking for is always a good thing, especially if one is looking to get rich.

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

Gearing

For example:

Loans  $6 million

Shareholders' funds $3 million

Gearing 200%

The purpose of this ratio is to compare the finance provided by the banks and other borrowing with the finance invested by shareholders.

It is a ratio much used by banks, who may not like to see a ratio of 1 to 1 (or some other such proportion) exceeded.

The ratio is sometimes expressed as a proportion as in 1 to 1.

Sometimes it is expressed as a percentage:  1 to 1 is 50% because borrowing is 50% of the total.

Gearing is said to be high when borrowing is high in relation to shareholders' funds.

This can be dangerous but shareholders' returns will be high if the company does well  

This is what is meant by being highly geared.

The more debt you take on, the higher the risk

The higher the net gearing figure, the riskier the investment becomes.  This is basically because debt has to be paid back no matter what happens to your sales.  Costs are generally more fixed, whilst income for most businesses is variable and can fluctuate wildly.  

For example, the manufacturer of high-end electronic consumer goods that is very heavily geared is likely to face a potentially serious problem in the event of a sudden economic downturn.  The debt, however, as a fixed cost, would remain.  This is how large numbers of businesses go under.

A business in the same sector with little or no debt and a healthy bank balance is far more likely to weather the economic storm.  Recessions are nothing new, they have happened before and will do so again.

Does any business really have an excuse for not being prepared for them?  



[So the world will almost certainly face further financial shocks and economic events that will surprise us, and whilst we can't say when it will happen or how exactly it will play out next time around, sometimes it really can feel like a little bit of history repeating as the stock market will continue to behave in both a rational and irrational manner without warning. 

That is why it is so important to think about the business, and not the share price or even what the market is really doing at all.]

Evaluating a Company - 10 Simple Rules

Having identified the company of interest and assembled the financial information, do the following analysis.

1.  Does the company have any identifiable consumer monopolies or brand-name products, or do they sell a commodity-type product?

2.  Do you understand how the company works?  Do you have intimate knowledge of, and experience with using the product or services of the company?

3.  Is the company conservatively financed?

4.  Are the earnings of the company strong and do they show an upward trend?

5.  Does the company allocate capital only to those businesses within its realm of expertise?

6.  Does the company buy back its own shares?  This is a sign that management utilizes capital to increase shareholder value when it is possible.

7.  Does the management spent the retained earnings of the company to increase the per share earnings, and, therefore, shareholders' value? That is, the management generates a good return on retained equities.

8.  Is the company's return on equity (ROE) above average?

9.  Is the company free to adjust prices to inflation?  The ability to adjust its prices to inflation without running the risk of losing sales, indicates pricing power.

10.  Do operations require large capital expenditures to constantly update the company's plant and equipment?   The company with low capital expenditures means that when it makes money, it doesn't have to go out and spend it on research and development or major costs for upgrading plant and equipment.


Once you have identified a company as one of the kinds of businesses you wish to be in, you still have to calculate if the market price for the stock will allow you a return equal to or better than your target return or your other options.  Let the market price determine the buy decision.  

A quick look at Nam Fatt - PN17 (1.5.2010)

Nam Fatt Corporation Berhad Company

Business Description:
Nam Fatt Corporation Berhad. The Group's principal activities are constructing bridges, heavy concrete foundations, roads, factory complexes and other similar construction activities. Other activities include building, maintaining and operating the Jiangjin Bridge on a built-operate-transfer basis, constructing projects in the oil, gas and petrochemical related industry, steel fabrication, structural steel engineering, manufacturing and trading steel doors and industrial boilers, researching, developing, producing, selling, installing and maintaining metal roofing and wall cladding, manufacturing galvanised iron roofing sheets, property development; owning and developing golf resort and its recreational amenities, property developer and property manager, resort and development, managing a golf resort and recreational clubs and investment holding. The Group operates in Malaysia, Africa and Asia.

Currency: Malaysian Ringgits
Market Cap: 28,763,370
Fiscal Yr Ends: December
Shares Outstanding: 319,593,000
Share Type: Ordinary
Closely Held Shares: 35,229,890 (11%)

16/03/2010
NAMFATT - New admission into PN17

Wright Quality Rating: LCNN Rating Explanations








A quick look at Nam Fatt - PN 17 (1.5.2010)
http://spreadsheets.google.com/pub?key=tAskkNgs3uU8eyk_WrTFcSw&output=html

Some RED FLAGS (hindsight) in the accounts of Nam Fatt at end of 2008 to note are:

Share price 
RM 0.19  or market capitalisation of 34.16 m. (The price rose to RM 0.30 from March 2009 and dropped precipitously to RM 0.09 when the news of the company's financial problem was known.)

Income statement
Negative earnings -14.09 m
Interest expense -18.73 m

Cash flow statement
Negative CFO  -41.27 m
Neglible CFI
Negative FCF  -44.10 m
CFF  -34.11 m (Borrowings increased significantly)

Balance sheet
Total Debt 499.69 m
Account Payables' Days 206.58 days  (This then increased to 714.24 days in end of 2009)
Interest cover 0.66
Total Debt/Equity 0.82
Net Debt to EBITDA 26.64  (Ideally, this should be less than 5.  Bankers do not lend if this ratio exceed this figure.)

Of interest, these commonly used parameters DID NOT raise any red flags at end of 2008:

Equity 607.44 m (What is the actual value?!)
NAV 1.59
Current ratio 1.54
Quick ratio 1.51
Account Payables' Days 82.22 days (Though this subsequently ballooned to 307.08 days in end of 2009)
LTD/Equity 0.34
Dividend 2.08 m


Related article:

Measure long-term solvency and stability

Assessing indebtedness. How much debt is too much?

Acceptable debt

Debt and Leverage: Financial weapon of mass destruction

Be fearful of excessive leverage and debt

Buying Stocks on the Verge of Bankruptcy

8 Signs Of A Doomed Stock

Red Flags and Pitfalls for Avoiding Financial Fakery

Asset valuation approach in liquidation

Liquidation value is the net realizable amount that could be generated by selling a company’s assets and discharging all its liabilities.

When valuing a business for liquidation, most assets are marked down and the liabilities treated at face value. 

• Cash and securities are taken at face value.
• Receivables require a small discount (perhaps 15 percent to 25 percent off).
• Inventory a larger discount (perhaps 50 percent to 75 percent off).
• Fixed assets at least as much as inventory.
• Any goodwill should probably be ignored.
• Most intangible assets and prepaid expenses should beignored.

The residual is the shareholders’ take.

This valuation method is useful for companies being dissolved.

Risk of Loss Caused by a Company's Indebtedness

Companies that choose to finance a large proportion of their assets with borrowed money face an increased risk of being unable to meet their financial obligations.  The greater a company's reliance on debt, the more likely that the company will be unable to service the required interest and principal payments that come from debt.  A large amount of debt also tends to produce large variations in a firm's net income, which places the stockholder in a riskier position because it is more difficult to forecast earnings and dividends.

A company that relies mostly on earnings and owner contributions to pay for new assets has few fixed financial expenses to meet and is likely to be able to continue to meet its financial obligations when it encounters difficult economic conditions.

• A business with a substantial amount of debt is likely to encounter difficulties when revenues decrease.  
• Difficulties may also arise when revenues increase more slowly than the firm's management expected at the time the funds were borrowed.

If being in debt is so risky, why do most companies so readily employ this method of financing?  

• The answer is that debt allows a company to acquire more assets and grow more rapidly than would reliance solely on earnings and stockholders' contributions.  
• A company that conscientiously avoids borrowing money may have to delay its expansion plans because of the limited funds available to pay for new assets.  
• Delayed expansion may allow the firm's competitors to gain an advantage by reaching new markets or developing new products first.  
• A delay in expansion plans may also keep a firm from being among the first in its industry to reach a cost-efficient size.

Borrowing money rather than issuing additional shares of stock permits a business to expand without having to share control and profits with additional owners.  The firm also saves on future dividend payments.

• A firm that borrows $500,000 avoids having to sell thousands of additional shares of common stock on which dividends are likely to be paid in the future even if no dividends are currently being paid.  
• In addition, while dividend payments to stockholders must be paid from after-tax income, interest paid on debt is permitted as a deduction in calculating taxable income.  
• In other words, the interest expense from borrowing results in a tax benefit for the borrower.

Another potential advantage of borrowing is that debt financing will allow a company that experiences favourable business conditions to earn a higher return on the stockholders' investment.

• A decision to seek a long-term loan at a fixed rate of interest can prove to be a very wise decision if a company's productivity and revenues grow.  The fixed interest expense means that a substantial proportion of revenue growth is likely to flow down as profits for the stockholders.

Assessing indebtedness. How much debt is too much?

Leverage

Leverage and debt assessments are perpetually subjective and are discussed continuously by financial and credit analysts. Some debt is usually regarded as a good thing, for it expands the size of the business and hence the return on owner capital/equity. But too much is too much. Where do you draw the line?

Guiding principles include comparative analysis and vulnerability to downturns. Debt must always be paid back, whether business is good or not - so debt stops being okay when it's too large to cover during a downturn or business strategy change.

Here are a couple of supporting metrics:

Debt to equity

This old standard is common used to get a feel for indebtedness, particularly in comparison with the rest of an industry.

D/E = Total long-term debt / Equity

A company with only $300,000 in long-term debt beyond the portion currently due, against $653 million in equity is virtually debt-free. Such a debt to equity ratio well below 1% is healthy, and so it is for most businesses too. But business analysts may wonder if the company could produce a greater return by borrowing and putting more assets in play. Evidently management has decided that it isn't worth it, so hasn't. That's a better decision than borrowing funds to make the wrong investments.

The investor is left to agree or disagree with management's judgment, but debt-free companies - just like debt-free consumers - come out ahead more often.


Interest coverage

Interest coverage is the ratio of earnings to annual interest, a rough indication of how solvent or burdened a company is by debt.

Interest coverage = Earnings / Annual interest

One way to look at whether a business has the right amount of debt is to look at how much of its earnings are consumed to pay interest on it. (Prudent to keep annual interest less than 20% of earnings.)

When looking at interest coverage, a good question to ask is this: What happens to coverage if, say, business (sales) drops 20%, as in a deep recession?