How a company’s debt can cripple shareholders | Fin24
 
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How a company’s debt can cripple shareholders

Mar 14 2019 08:48
Simon Brown

In his annual letter to Berkshire Hathaway shareholders, Warren Buffet talks about debt, an area I feel warrants particular attention.

Improving profits in a business comes from improving margins, product lines and general market growth. 

But from time to time a business will grow via debt or equity. 

Generally, using debt works well enough. 

You borrow money at say 10% and buy or build an asset that returns 12% – you’re ahead of the curve from day one. 

The risk, of course, is changing interest rates or returns that do not go as expected.

Recent times on the JSE have shown how a significant number of companies undertook large acquisitions or projects, which ended up costing more and delivering less than promised – and also took longer to get going.

Debt certainly helps juice returns for shareholders but in his letter, Buffett refers to “a Russian roulette equation – usually win, occasionally die”. 

In other words, when debt works it’s great; profits grow, and management and shareholders get rewarded. 

But every so often credit vanishes, debt costs soar and the whole thing collapses. 

Often with fatal results. 

Importantly, those fatal results affect the company and the shareholders. 

Management just rushes for the exit and moves onto the next adventure, usually keeping the rewards earned while stacking up the debt that ultimately became crippling.

As investors, we need to keep a very careful eye on debt levels in the stocks we own, even during the good times. 

Perhaps especially during the good times because when the bad times arrive, it is simply too late to do anything. 

There is, of course, recourse for excessive debt and that’s often a large rights issue. 

This either dilutes existing shareholders’ holdings or requires them to put more money into the business in the hope that it survives long enough to reward them. 

Not an ideal situation.

There are a number of ways you can keep an eye on debt.

Firstly, via a debt-to-equity ratio, which simply compares debt on the company’s balance sheet to the equity. 

You can then compare this figure to previous years and against the company’s peers in the sector to get a sense of its debt burden. 

Is it rising or falling, and why? 

This ratio should be falling as equity increases and debt is paid off over time. 

The exception being when a new tranche of debt is raised for a project.

To get an idea of how manageable the debt burden is, you can then look to the interest cover: profit before interest and tax payments divided into the interest payments. 

A level of 1.5 times or lower should raise some red flags, as any blip on the earnings front could see the company struggling to pay off the debt and heading for that rights issue.

Another figure to consider is the current ratio, which looks at current assets against current liabilities. 

Current means due (or redeemable if an asset) in the next 12 months. 

If the current liabilities exceed current assets, then there are more red flags.

A last point is to look at the debt profile as detailed in the annual report. 

This will tell you when debt expires and may have to be rolled over, and will also detail debt covenants that, if breached, could see lenders recall the debt.At the end of the day debt can be useful, but it can also be a game of Russian roulette with shareholders the victims – so watch it closely. 

This article originally appeared in the 21 March edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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