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I have written about debt before, but I want to focus on it again in this column as it is a very important contributor to a company’s growth. Yet, it can also lead to a firm’s downfall.
If used carefully and within manageable levels, debt certainly helps a business grow. For example, if you can borrow money at 10% and grow, buy or build a new profit centre that makes a return of 12%, you’re ahead of the game. And even more so once the debt is paid off.
The first thing is to understand a few key debt ratios, with the most popular being debt-to-equity (DE). This presents the total debt as a percentage of the equity of a company (equity is from the balance sheet and is assets less liabilities).
Typically, a company would maybe have a 50% DE level. But what’s important is to watch the trend over time, compare the business to its peers and monitor what management’s DE target is.
At times a business may do a big deal that sends the DE higher, like Famous Brands* did with its acquisition of Gourmet Burger Kitchen in the UK.
In this case the company suspended dividend payments in order to tackle the increased debt aggressively.
Others, such as Aspen, typically have a high DE as they are consistently making acquisitions. In this pharmaceutical player’s case, the cash generated from these acquisitions typically pays off the new debt.
The risk of course is that if an acquisition goes wrong and doesn’t generate cash flow, it can put a strain on the company’s ability to cover the repayments, and so interest cover becomes important.
Interest cover is a company’s earnings before interest and tax (ebit) divided into the company’s interest payments for the period.
Here an ideal number is at least two times, but if earnings are cyclical, then even higher is better.
I also take note of the current ratio – current assets (usually cash, inventories and receivables) compared to debt due within the year. Current assets and liabilities on the balance sheet are those due within the next 12 months. This gives a quick indication whether a company is able to meet short-term debt.
I also want to get a detailed picture of the debt structure. Here we need to wait for the annual report in which the company will publish all the details, such as when the debt is due and the interest rates.
Staying with the annual report, I want to dig into the debt covenants. A lender will often put some conditions on the debt. For example, they could state that if margins drop below a certain level, the debt is immediately repayable.
This is hugely important for stressed companies as a worsening situation could suddenly lead to debt being recalled, leaving the company in an even worse position.
So, while debt is my preferred way for a company to grow (as opposed to issuing new shares), we as shareholders need to keep a careful eye on the debt pile and make sure that we consider it to be manageable.
The company will comment on its debt and have target ratios, but we as investors also need to do our own digging.
We need to remember that when things are going well debt is seldom a concern, with the company either raising it or paying it. But when things turn nasty suddenly, that pile of debt can be what sinks a company.
*The writer owns shares in Famous Brands.
This article originally appeared in the 1 February edition of finweek. Buy and download the magazine here.
