Rising interest rates have forced investors to reappraise the composition of their portfolios as we exit the era of easy money. Most prominently, the orthodox view on the 60/40 mix of stocks and bonds has come under increased scrutiny, while investors will also be looking at their exposure to the property market as base rates tick up. Above all, however, if you hold individual stocks within your portfolio, it is advisable that you take a more granular view of their debt servicing arrangements.
There are several widely used measures to determine a company's ability to repay its borrowings, or to take on new financing. The debt service coverage ratio (DSCR) is often used in conjunction with the quick ratio to this end, but the results can best be described as indicative – you will usually need to dig a little deeper to make a comprehensive judgement. That means getting up to speed with debt covenants, repayment schedules, credit ratings, interest rate variability and debt-to-equity ratios. It could even involve looking at things like earn-out provisions if a company’s debt has been accumulated through M&A activity.
The DSCR describes trading profits as a multiple of debts payable within 12 months, while the quick ratio is based on a company’s ability to utilise its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities. A DSCR of less than 1 points to negative cash flow, meaning that that the borrower will be unable to cover or pay current debt obligations without drawing on other sources, be that debt or equity.
Beyond the burden of meeting current obligations, it is possible to get a steer on a given company’s overall debt capacity by employing the net debt-to-Ebitda (cash profit) ratio, another commonly used metric. As its name suggests, it is calculated by dividing cash-adjusted debt by earnings before interest, taxes, depreciation, and amortisation. It is regularly used by rating agencies to determine the probability of default on issued debt. A high multiple could conceivably result in a lower credit score for a business, thereby increasing financing costs, or even restricting access to credit lines.
All of this has implications for any investors who have rejigged their portfolios to take advantage of companies with high dividend yields as a means of mitigating inflationary pressures. There are currently 13 stocks within the FTSE 350 whose dividend yield is in advance of the 9.9 per cent rise in the Consumer Prices Index in the 12 months to 31 August. As often as not this merely reflects a slump in the share price, but there are some companies further down the pecking order whose ability to fund shareholder returns is enhanced by the cash-generative nature of their businesses.
Unfortunately, with a higher-for-longer interest rate mantra njow in effect, many companies could be forced to prioritise debt reduction at the expense of shareholder returns. For some, like Imperial Brands (IMB), that imperative held sway as far back as May 2020 when the UK base rate stood at just 0.1 per cent. The tobacco group took the decision to pare back its half-year dividend by a third in an effort to reduce gearing down to the bottom end of its 2-2.5 times that range by the end of 2022. Happily, it achieved the lower end of the target range ahead of time and duly announced a £1bn share buyback programme.
We will have to wait until 15 November to assess whether its borrowing arrangements are likely to constrain surplus capital and dividend growth. We highlighted the income case in an August 2020 stock screen – '10 Safe Yield shares', IC 11 August 2020 – but we will need to recalibrate assumptions in view of the new interest rate environment.
Nonetheless, through to the March 2022 half year, the group extended the maturity date of its existing revolving credit facility of €3.5bn (£3.04bn) to March 2025. There are also forex considerations to take on board as around a quarter of its debt is denominated in US dollars. Consensus forecasts point to a 3 per cent increase in the annual dividend to 142.8p. That’s hardly extravagant, but a quick ratio of 0.4 indicates an inadequate degree of liquidity and it is probable that increased cost of capital formed part of the deliberations.
The overall forecast debt position, equivalent to 2.1 times cash profits, has pulled back appreciably since the end of 2020 and is trending downwards. So, on balance, and short of any unpleasant revelations on the trading front, we feel that Imperial – yielding 7.96 per cent on a forward PE multiple of 8.9 at the time of writing – will be able to support its current level of distributions.
