Concept of Interest Coverage is akin to Concept of Margin of Safety

INTEREST COVERAGE

Interest Coverage:  This is the number of times that interest charges are earned, found by dividing the (total) fixed charges into the earnings available for such charges (either before or after deducting income taxes).

Interest Coverage
=  Earnings (before or after income tax) / total interest charges



MARGIN OF SAFETY

Margin of Safety, in general, is the same as "interest coverage."

Formerly used in a special sense, to mean the ratio of the balance after interest, to the earnings available for interest.

Margin of Safety
= Balance of earnings after interest / Earnings available for interest.

For example:

Interest  $100
Earnings  $175

Interest cover $175/$100 = 1.75x
Balance after interest = $175 - $100 = $75

The margin of safety (in this special sense) becomes
= $75 / $175
= 42.86%

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

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.

Capital Structure, Dividends and Share Repurchases

There is usually more to lose than to gain when making a decision in this area.

Managers should manage capital structure with the goal of not destroying value as opposed to trying to create value.

There are three components of a company's financial decisions:

1. how much to invest,
2. how much debt to have, and 
3. how much cash to return to shareholders.

Choices concerning capital structure

Managers have many choices concerning capital structure, for example,

1. using equity,
2. straight debt,
3. convertibles and
4. off-balance-sheet financing.

Managers can create value from using tools other than equity and straight debt under only a few conditions.

Even when using more exotic forms of financing like convertibles and preferred stock, fundamentally it is a choice between debt and equity.




Debt and Equity Financial Choices trade-offs

Managers must recognise the many trade-offs to both the firm and investors when choosing between debt and equity financing.

The firm increases risk but saves on taxes by using debt; however, investing in debt rather than equity probably increases the tax liability to investors.

Debt has been shown to impose a discipline on managers and discourage over investment, but it can also lead to business erosion and bankruptcy.

Higher debt increases the conflicts among the stakeholders.




Credit rating is a useful indicator of capital structure health

Most companies choose a capital structure that gives them a credit rating between BBB- and A+, which indicates these are effective ratings and capital structure does not have a large effect on value in most cases.

The capital structure can make a difference for companies at the far end of the coverage spectrum.

Credit ratings

• are a useful summary indicator of capital structure health and 
• are a means of communicating information to shareholders.

The two main determinants of credit ratings are

• size and 
• interest coverage.

Two important coverage ratios are

• the EBITA to interest ratio and 
• the debt to EBITA ratio.

The former is a short-term measure, and the latter is more useful for long-term planning.




Methods to manage capital structure

Managers must weight the benefits of managing capital structure against

• the costs of the choices and 
• the possible signals the choices send to investors.

Methods to manage capital structure include

• changing the dividends, 
• issuing and buying back equity, and
• issuing and paying off debt

When designing a long-term capital structure, the firm should

• project surpluses and deficits, 
• develop a target capital structure, and 
• decide on tactical measures.  

The tactical, short-term tools include

• changing the dividend,
• repurchasing shares, and 
• paying an extraordinary dividend.

Prudent financing

Having a load of debt is not itself a bad thing.

Having a loa of debt that cannot be easily financed by the cash flow of the business is a recipe for disaster.

When analysing companies with high debt, always be sure that the debt can be serviced from free cash flow, even under a downside scenario.

A practical analysis of dividend

A Practical Analysis Of Unilever Plc's Dividend

By Royston Wild | Fool.co.uk

The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.

There are a variety of ways to judge future dividends, and today I am looking at Unilever (NYSE: UL - news) to see whether the firm looks a safe bet to produce dependable payouts.

Forward dividend cover

Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:

Forward earnings per share ÷ forward dividend per share

Unilever is expected to provide a dividend of 88.8p per share in 2013, according to City numbers, with earnings per share predicted to register at 139.1p. The widely-regarded safety benchmark for dividend cover is set at 2 times prospective earnings, but Unilever falls short of this measure at 1.6 times.

Free cash flow

Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:

Operating profit + depreciation & amortisation - tax - capital expenditure - working capital increase

Free cash flow increased to €5.14bn in 2012, up from €3.69bn in 2011. This was mainly helped by an upswing in operating profit -- this advanced to €7bn last year from ?6.43bn in 2011 -- and a vast improvement in working capital.

Financial gearing

This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:

Short- and long-term debts + pension liabilities - cash & cash equivalents

___________________________________________________________            x 100

                                      Shareholder funds

Unilever's gearing ratio for 2012 came in at 56.6%, down from 59.5% in the previous 12 months. The firm was helped by a decline in net debt, to €7.36bn from €8.78bn, even though pension liabilities edged higher. Even a large decline in cash and cash equivalents, to €2.47bn from €3.48bn, failed to derail the year-on-year improvement.

Buybacks and other spare cash

Here, I'm looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.

Unilever does not currently operate a share repurchase programme, although it remains open to committing capital to expand its operations around the globe. Indeed, the company is attempting to ratchet onto excellent growth in developing regions as consumer spending in the West stagnates -- the firm saw emerging market sales rise 10.4% in quarter one versus a 1.9% fall in developed regions.

The firm remains dogged in its attempts to acquire a 75% stake in India's Hindustan Unilever (BSE: HUL.BO - news) , for example, and I expect further activity to materialise in the near future. Meanwhile, Unilever is looking to reduce its exposure to stagnating markets by divesting assets, exemplified by the recent sale of its US frozen foods business.

An appetising long-term pick

Unilever's projected dividend yield for 2013 is bang in line with the FTSE 100 (FTSE: ^FTSE - news) average of 3.3%. So for those seeking above-par dividend returns for the near-term, better prospects can be found elsewhere. Still, the above metrics suggest that the firm's financial position is solid enough to support continued annual dividend growth.

And I believe that Unilever is in a strong position to grow earnings strongly, and with it shareholder payouts, further out. Galloping trade in developing markets, helped by the strength of its brands -- the company currently boasts 14 '€1 billion brands' across the consumer goods and food sectors -- should significantly bolster sales growth and thus dividend potential in my opinion.

Tune in to hot stocks growth

If you already hold shares in Unilever and are looking to significantly boost your investment returns elsewhere, check out this special Fool report, which outlines the steps you might wish to take in order to become a market millionaire.

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> Royston does not own shares in Unilever. The Motley Fool has recommended shares in Unilever.

http://uk.finance.yahoo.com/news/practical-analysis-unilever-plcs-dividend-090040474.html

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

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?