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Recently I wrote about companies undertaking acquisitions with debt. At the same time I mentioned PPC, which is in a pile of trouble over its debt (see graph below).
The reality is that debt can be great or horrid; it is the true double-edged sword. Use it well and a company can grow ahead of just its organic growth rate. Use it badly and a company could at worst go bust or perhaps just escape with a nasty rights issue. So this week I want to focus on what we need to know about debt.
First, where do we find it? The balance sheet will list two types of debt – current debt that needs to be repaid within a year, and non-current that has more than a year to go until it needs to be repaid. The simplest measure is to check current debt against current assets.
If debt is larger (as with PPC), then there is a problem. We can also check the debt-to-equity value, again from the balance sheet, and here the different industries will have different levels, but typically I want to see debt at about 80% of equity at the most.
Another important ratio is interest cover. This is usually profit before interest and tax, into which we divide net interest paid. Again this gives us an idea of how well the company is able to make the interest payments. We always want a number above 1, but above 2 (or even higher) is better. Below 1 means they can’t service the interest payments, never mind the principle debt amounts.
But we need to understand what the debt is and here PPC did its shareholders a great service when it published full details of all its debt in the last set of results. Typically, one has to go to the annual report to get the details and by then the information is very old.
You want to see what interest rates they are paying for the debt. Is it expensive debt that they agreed to as they had no other options? Even if a company can afford a higher interest rate on debt, it does mean that it is spending more on interest every year, which will hurt profits.
We also want to see when the debt expires. If a large portion of debt is expiring, say, next year, what is management’s plan – does it want to repay the debt or perhaps refinance it? Have rates risen, maybe making the refinanced debt more expensive? Here we’ll also sometimes see an overdraft being used for debt and this is never good.
An overdraft is expensive and can be recalled without notice and always raises the question as to why a company doesn’t have formal loans in place instead of expensive high-risk overdrafts.
Another very critical issue is debt covenants. These are clauses included in the terms of the debt that, if breached, may trigger an immediate payment of the debt. This is what happened to PPC – the downgrade by Standard & Poor’s has caused it to be in breach of its debt covenants and the debt holders can now request repayment of the debt within a specified period.
These covenants will focus on the ratings but also potentially on the size of overall debt and maybe even on the profitability or margins of the company. These covenants are hard to find but should be included in the annual reports; read them and see if the company is at risk of breaching them.
So, like many things, debt can be good or bad, and it is vital to understand how it is impacting the companies we’re invested in.
This article originally appeared in the 7 July edition of finweek. Buy and download the magazine here.
