Investing 101
Tools I use
Asset Allocation
Powered by Blogger.
20 Sept 2011
5 Ways to Measure Debt
To most value investors, debt is one of the first things
they look at when analysing a company.
Since value investing, almost by definition, involves buying unpopular
stocks, there is often some kind of bad news surrounding the company which will
only be made worse by high levels of debt.
The problem with debt
Debt, in itself, is not a bad thing and is vital to almost
every company in some way or other. Some
debts are short term and interest free, such as credit from suppliers, while
other debts are longer term and do incur interest. In most cases it is the interest bearing
debts that are the danger, although in some cases a sudden reduction of
incoming cash can cause a cash flow crisis where suppliers cannot be paid.
Debt and the turnaround situation
I used to invest in small and struggling turnaround
situations and for these companies debt was a major worry. Although these stocks can often be picked up
at ‘bargain’ prices and sold for big profits at a later date, the risks posed
by debt are substantial.
For small and struggling companies the current and quick
ratios are a good place to start.
The current ratio is the ratio of current assets to current
liabilities. There are no hard and fast
rules but many value investors prefer a ratio of 2 or more in order to ensure sufficient short term liquidity. This can be a rather limiting rule that is only really suitable for turnarounds rather than solid, healthy companies.
The quick ratio is the ratio of quick assets – those which
can be turned to cash within 30 days or so – to current liabilities. An alternative to working out the true quick
assets is to remove inventory from current assets and use that figure. The idea is that often inventory cannot be
turned in to cash quickly and would be of no use in generating cash during a
cash crisis. A quick ratio of more than 1 is enough to keep most value investors happy although again, this can be limiting if applied to healthy companies.
Debt and the wonderful company
I no longer invest in small and struggling companies and
instead much prefer the advice of Warren Buffett who said, “It’s far better to
buy a wonderful company at a fair price than a fair company at a wonderful
price”. With these ‘wonderful’
companies, debt is usually much less of an issue and most of the time I pay
little attention to the current and quick ratios. For a company which is currently highly
profitable and cash generative, they are not particularly important.
For the ‘wonderful’ companies, the level of long term
interest bearing debt is more important – although long term debt is important
for the turnaround companies too.
One way to measure long term debt is with something called
gearing, which has various definitions but I tend to use the ratio between net
debt (interest bearing debts minus cash equivalents) and shareholder
equity. Many value investors are only
interested in companies where gearing is below 100% and this is certainly a
measure I used to use, although I preferred tangible gearing which ignores
intangible assets when calculating shareholder equity.
Gearing does have its problems though
Take Imperial Tobacco for example. It has gearing of around 150%, putting it
outside of the old 100% maximum rule.
But is that really too much debt for the company to handle? Has that debt held them back in the past and
does it constitute a risk to the company’s survival?
It certainly doesn’t seem to have held them back. Revenue, earnings and dividends have all
grown by more than 200% in the last decade, while gearing has been up to and
over 5,000%. This shows how gearing can
be skewed into absurdity by the capital structure of a business.
As for constituting a risk to the company’s future, the
interest cover on the debt is over 7, which is the ratio of operating profits to
interest. This means that only 1/7th of this year's profits are being used to pay interest. An interest cover of less than 5 is considered too low by many investors, so 7 is quite low but certainly not dangerous for a company with
such stable and recession proof earnings as Imperial Tobacco. Even in the unlikely event that earnings fell to half their current level for the foreseeable future, the interest would still be covered more than three times over.
Another check on the sustainability of debt is to look at
the ratio of interest bearing debt to operating profits. If debts are more than 5 times operating profits then that may become a problem if earnings come under pressure at some
time in the future. For Imperial Tobacco
the debts are less than four times the latest operating profits, which means
that the debt does not look excessive even though gearing is 150%.
Debt is a risk good companies don’t need
Debt is often used as a way to grow a company quickly,
without regard for its long term robustness and sustainability. When a company has high debts,
not only is it a riskier proposition but it may also be telling you something
about the priorities of the management (i.e. to grow fast, look good, get on
the cover of magazines and win awards - at least for a while).
Equally, if a company has few debts it may be telling you
something else about the quality of the business. As Warren Buffet has often said, “really good
businesses usually don’t need to borrow”.
As a value investor, debt is the risk you don’t need to
take.
Labels:
Value Investing 101
Subscribe to:
Post Comments (Atom)
Sponsored links
If you're planning on starting your own business, take a look at our range of start-up packages
We show you how to shape your business idea with a small business plan
Thinking of starting a business? We offer business advice, support and a range of banking services
We're not just about providing you with a bank account – we offer business support as you grow your compa
As seen on
3 comments:
I've taken to looking at (debtors + cash) - (short term creditors) in the first instance and then looking at long term debt. I am not sure that looking at any single figure is reliable enough, though.
The usual problem is that reported figures on trading and cashflow are historical whereas the simple d+c-stc is something that has at least some validity into the near future. Companies usually don't say that sales are beginning to fall off a cliff and I like to know that there is something in the coffers with which to weather a downturn.
Hi Anon, thanks for your comment. If you're looking at turnarounds then I'd say your d+c-stc seems like a nice idea, but as you say a single measure isn't enough.
These short term liquidity issues can get pretty complex, with things like inventory turnover and cash burn rates coming into the picture.
Those additional risks and complexities are part of the reason I moved toward a mix of Ben Graham 'defensive' investing and Buffett's 'inevitables'. Most of the time short term liquidity isn't an issue.
Yeah, Debt is surely an important thing to be considered for investor. Too much debt means that the company is owned by the creditor and not by investor. It is meaningless to invest for such company.
Post a Comment