Identifying the ‘seven deadly sins’ of company debt

There are plenty of ways for investors to lose money in the short term but one sure-fire way to make that loss permanent is to buy into a company with a weak balance sheet. And one sure-fire route to a weak balance sheet is to take on ill-considered amounts of debt – which is why, here on The Value Perspective, we put a lot of time and effort into analysing the indebtedness of businesses.

Whether we are weighing up buying into a business or reassessing one we already own, we work through a list of seven different checks, which we have come to refer to as the ‘seven deadly sins’ of company debt. The first thing we look at is ‘solvency ratios’ as we aim to answer the all-important question of whether a business has ‘too much’ debt.

There are a lot of ways to think about this – you could measure a company’s indebtedness against its average profitability, say, or against its tangible assets. Here on The Value Perspective, we look at the issue through several different lenses but ultimately we are trying to decide whether a business has taken too much debt in the context of its long-term profits.

Covenant ratios

Second on our list is ‘covenant ratios’ – in other words, does the company’s bank think it has too much debt? It is all very well for us to formulate a view on whether or not a business has an appropriate level of gearing but, in the end, it is the bankers who have to lend the money. That will play a significant part in defining whether the business has too much debt, so understanding the covenant ratios banks focus on is crucial.

‘Liquidity’ is next – in effect, how long-term is the debt? A business may have a great-looking balance sheet and some undemanding banking covenants and yet, if its debt has to be renegotiated tomorrow, it could be in trouble. As we touched on in Inevitable side-effect, we recently saw this with cruise operator Carnival, which had to renegotiate a lot of debt at a very painful time and ended up paying a very expensive rate of interest.

Fourth on our list is ‘debt repayment’ – to what extent is the business trapped by its indebtedness? Does it have the ability to climb out of that hole by itself – or will it need help from others? And speaking of other people, our next consideration is ‘pensions and other creditors’ – that is to say, how many people will be standing ahead of us in the queue when it comes to getting paid?

Company stakeholders

When times are good, it can seem as if businesses only have two sets of stakeholders – debt holders and equity holders. When times turn tough, however, that queue can suddenly grow very long and daunting, with pension funds, staff, suppliers, landlords and more having a greater claim on a company’s assets. That may not leave much, if anything, for equity holders and you have to understand that ahead of time.

Next up is ‘working capital’, which sees us assessing how quickly things can take a turn for the worse. In the final analysis, it is not indebtedness that will send a company bust, it is cashflow. Sooner or later, a company is going to need cash in hand to make a payment to someone and, if that moment comes and it does not have the money readily available, that is when the lights get turned out.

That brings us to the final point on our checklist – ‘cash conversion’. If a business does not have any cash when it needs it, how likely is it to be able to solve the problem itself? Or, to put it another way, does it actually generate cash through the cycle? Those are the seven deadly sins of company debt and, if as an investor you do not pay adequate attention to them in your analysis, well, that particular sin is on you.

Seven deadly sins – More than one way to scan a debt

* Solvency ratios

* Covenant ratios

* Liquidity

* Debt repayment

* Pensions and other creditors

* Working capital

* Cash conversion

Source: The Value Perspective