Lockdown reveals the harsh truth about balance sheets and buybacks

Borrowing money to finance a business adds financial gearing or leverage to a company’s trading profits. This means that the change in trading profits will magnify the change in pre-tax and post tax-profits. This gearing works both ways and is great when the company is growing its trading profits, but can be very painful when they are falling.

Investors need to understand how financial leverage works for and against and should never let it fool them that a business is performing better than it really is. This often gets forgotten in an upswing, but a painful lesson is then learned when trading turns down. 

They should also never pay up for leverage on the basis that it is driving earnings per share (EPS) growth. Focusing on trading profits and not ones that have been financially engineered – as pre-tax and post tax profits can be – is the best way.

This can be illustrated with a very simple but powerful example that experienced investors will know all too well but is worth repeating nonetheless.

How financial gearing affects shareholders’ profits

Let’s compare two identical companies that have invested £1bn in their assets and are both earning £200m in trading profits a year (a return on investment of £1bn or return on capital employed (ROCE) of 20 per cent).

Company A has no debt. Company B has lots of debt. It has chosen to finance its £1bn of assets with £800m of debt with an interest rate of 10 per cent and £200m of shareholders’ equity. Company B therefore has an £80m interest bill to pay every year. 

Company A

Company A: No financial gearing

Source: Investors Chronicle

Company A turns £1bn of sales into £200m of Ebit (earnings before interest and tax) and £160m of profit for shareholders after taxation at a rate of 20 per cent has been paid. To keep things simple, I’ve assumed that the percentage change in sales will feed through to the same percentage change in Ebit just to illustrate financial gearing. 

This won’t be the same in the real world as companies have operating costs that are fixed and don’t change when sales change. This gives rise to something known as operational gearing, which means that for a given percentage change in sales there will be a bigger percentage change in trading profits. The easiest way to spot a company with high operational gearing is to look at the track record of its turnover and trading profits. If you see that profits move up and down a lot over a long period of time that is usually a telling sign.

As you can see with the case of company A, with no financial gearing, the change in profits for shareholders mirrors the percentage change in sales. A 20 per cent change in sales leads to a 20 per cent change in profits. Even when sales fall by 20 per cent there is still £128m of profits for shareholders.

Company B

Here, the existence of debt and interest payments gears the change in profits for shareholders coming from a change in sales. Because the £80m of interest has to be paid come what may, it gears the profits for shareholders. Here a 20 per cent increase in sales leads to a 33.3 per cent change in profits.

Company B: Lots of financial gearing

That’s fine when times are good. However, during bad times shareholders take a big hit. Company B’s shareholders end up with half as much money as Company A’s.

There are different ways to measure a company’s financial gearing. The most popular measures are:

• Net debt to shareholders’ equity.
• Net debt to capital employed.
• Net debt to Ebitda (earnings before interest, tax, depreciation and amortisation).

I prefer to use total debt rather than net debt (where cash is deducted from debt) as a company’s cash balance is often not what it seems and it should not be assumed that it can be used to reduce a company’s debt.

The very simple lesson to take away is that too much debt can wipe out shareholders when profits collapse. The coronavirus lockdown has shown this very clearly.

Debt to capital employed is very much like comparing a mortgage with the price paid for a house. Mortgages can be based on very high loan-to-value multiples, but for non-financial, non-utility companies my rough rule of thumb is that once total borrowing exceeds half the value of money invested in a business it might be getting a bit too high.

We can see how high debts have geared the collapse in profits on company share price performance in 2020 (see High debts table below). Yet for years, companies have been encouraged to finance their businesses with more debt. This is because debt is theoretically cheaper than equity. Borrowers get paid before shareholders while the interest payments can be used to reduce a company’s tax bill (dividends paid to shareholders are not). 

High debts and 2020 share price performance

Source: SharePad. Total borrowing and capital employed based on last year-end balance sheet

Throw in ultra-low interest rates and it is no surprise that there has been a debt binge. The sad fact is that the bingeing has been going on in businesses that are already highly operationally geared and need very low levels of debt or ideally a pile of surplus cash for a rainy day.

This may be true for companies with robust and stable profits, but as with the last recession in 2008, weaker companies with fragile profits have been found to have too much debt. The lockdown is an extreme event which has seen companies run short of cash to run their businesses, but there should be no mistaking the fact that many of them had taken on far too much debt beforehand. High-street restaurants owned by highly leveraged private equity funds spring to mind here.

Companies with strong share price performances on the UK stock market in 2020 are few and far between, but for me it is telling that many of them have squeaky clean balance sheets with minimal amounts of debt (see Low debts table below).

Low debts and 2020 share price performance

Source: SharePad. Total borrowing and capital employed based on last year-end balance sheet

It has often been argued by academics that there is an optimal amount of debt that maximises the value of a business. For me, the weakness of this argument has always been that it does not adequately deal with the extra risk taken on by shareholders when a company adds debt. Strong businesses can have some debt without it being a problem, but for many no debt at all is the right course of action.

Have share buybacks really done any good?

Regular readers will know I am not really a fan of share buybacks. I see them as a form of financial engineering that largely benefits management with bonuses linked to EPS. They are often also a warning sign that a company has run out of profitable places to invest. Unlike the growth in profits and cash flows, I do not see them as a driver of company value unless they are bought for less than they are worth.

But my main gripe is that shareholders only really benefit if the buyback causes the share price to go up over the long haul and at times like this some buybacks are a long way from doing this. While I accept that I may be using an extreme event to prove my point, history is littered with companies that have squandered money on share buybacks, with long-term shareholders left scratching their heads how it has made them better off.

One of the best examples of this in recent times is Whitbread (WTB). The Premier Inn hotel owner sold its Costa Coffee business to Coca-Cola in 2018 for £3.8bn, which was more than many professional investors thought it was worth. It used around £1.3bn to pay down debt and reduce its pension fund deficit, which was positive for shareholder value.

It then spent £2.5bn buying back 49m shares at an average price of around £51 each. This compares with a share price today of £22.55 and an average analyst target price for the shares of £26. Shareholders would have been much better off with a special dividend or the company carrying a large cash balance to invest.

In the meantime they have been asked to stump up £1bn to shore up the company’s finances for new shares at £15 each in a rights issue.

Excess leverage and buybacks are more likely to make shareholders worse off. I hope that the future will bring a renewed focus on good old-fashioned financial prudence and investment in profitable businesses in an attempt to grow the value of shareholders’ equity instead.