The best borrowers

A similar pattern emerged ahead of the financial crisis after companies had built up their borrowings on easy credit. But once the crash took hold many companies found it difficult to find lenders willing to provide financing on such favourable terms. Instead, companies were forced to pay down their debt with internally generated cash or issue equity to raise new capital. Since then, debt has crept back up to surpass levels seen ahead of the financial crisis, undoubtedly fostered by years of easy monetary policy in the years following the crash.

Levels of investment needed to be maintained, while shareholders continue to expect rising dividend payments. Adding debt can sometimes act as a proxy for cash flow. According to research conducted by Link Asset Services and The Share Centre, in the three years to the end of March 2018, UK companies paid out £263bn in dividends, after having made profits of only £316bn. During the same three-year period their net debts rose by £122.6bn. By contrast, in the previous three years (2012-13 to 2014-15) net debt increased just £33bn, and dividends of £235bn were sufficiently covered by net profits of £381bn.

Such practices around debt and its uses could be why it might suffer a poor reputation with some investors. As an interest rate rise from the Bank of England looks ever more likely, high debt levels could be concerning. Higher rates would make it more expensive for companies to make the interest payments on their debt. Yet the debt profile of UK companies looks much different than it did ahead of the financial crisis. There’s been a greater emphasis on long-term debt, which is less exposed to changes in rates in the short term, and less on debt with a nearer maturity and therefore highly exposed to interest rate changes.

The nature of the business can also affect the level of debt it can maintain. Those with steady and predictable cash flows can service their debt with more certainty, while higher levels of debt could be more of a risk for those where cash flow is more uncertain, or cyclical. Similarly, those businesses underpinned by lots of assets can also comfortably take on more debt.

Debt as funding

Shareholders in a company often have a tricky relationship with debt. On one hand, debt can be used to finance value-enhancing projects for the company. On the other, it adds to the list of creditors who get paid ahead of equity holders should the company fall into financial distress.

The pecking order of financing, as taught by finance educators, suggests that companies should choose to fund projects through internal cash flows as first preference. This is not always possible depending on the nature of the company or the scale of the financing needed. The next preference should be to issue debt. Following that, convertible bonds can help mitigate disputes between bond holders and shareholders depending on the terms of conversion. Finally, issuing equity should be a last resort.

Debt is often a cheaper form of financing for companies. This is especially true if the company’s financial profile means it enjoys a higher credit rating. But it cannot be viewed in isolation. Shareholders may become nervous if a company begins to take on what they feel could be an excessive amount of debt, since equity holders get paid after debt holders. Credit is a promise to pay, while equity is not. Debt may be a cheaper form of funding, but the more debt is added, the more equity holders may demand as compensation for taking on additional risk.

Companies with a higher rate of corporate tax may be more inclined to opt for debt as a source of funding. Interest on debt is a tax-deductible expense, which means that debt creates what’s often referred to as a ‘tax shield’ for the company. Debt also allows the company to retain more control of its operations. When companies issue more equity, those new shareholders are given a say in how the company is run via voting rights. On the other hand, debt holders do not have any control of how the business operates; they just need to be repaid at the agreed maturity with the proper amount of interest paid over time. In a leveraged recapitalisation, debt can also be raised to buy back shares as a way to overhaul a company’s capital structure. This can be a means of increasing the share price.

A problem for another day

It’s not just the amount of debt, but the structure of corporate debt that’s changed over the past decade. The borrowings of UK public companies are now more weighted towards loans with a longer maturity date as opposed to those that will expire in the near term. If an interest rate rise is indeed on its way, or another market crash, this is a sensible structure.

A preference for longer-dated debt can help UK companies avoid mistakes of the past. Around 2008, more than a quarter of debt from UK public companies was due within one year, according to Link Asset Services. Once the availability of credit petered out in the wake of the financial crisis, debt with an impending maturity date had to be prioritised for payment. A year into the crisis short-term debt had been paid down by a third, whereas only a 6 per cent dent had been made in that with a longer maturity date.

Short-term debt has now fallen to around 18 per cent of company borrowings, while the proportion of longer-dated debt has continued to rise. This means that companies are more insulated from interest rate adjustments in the long term, and if another crash happens, companies will be under less pressure over short-term interest payments. Liquidity has also dramatically improved. Link research found that the value of cash and liquid investments was a third larger than short-term debt around 2008, but has grown to around twice as much today. Companies now look better prepared to withstand any pinches in credit availability than they were a decade ago.

Nature of the beast

Debt profiles can be as unique as the companies themselves, but some overarching trends can be found across sectors. Out of all the different types of companies listed in London, the consumer goods sector is the most highly indebted. According to Link, it accounts for nearly a quarter of all the debt incurred by UK public companies. Tobacco giants British American Tobacco (BATS) and Imperial Brands (IMB) together make up almost three-quarters of debt in the consumer staples sector. Add in Unilever (ULVR) and Reckitt Benckiser (RB.) and that’s most of the debt in the sector accounted for.

Housebuilders are also considered to be in the same sector as the consumer staples companies in the data set, but they tend to be cash-rich. In contrast to the tobacco giants, housebuilder Persimmon (PSN) currently has the highest cash balance of all UK-listed companies at £1.3bn. This is likely to be a calculated move rather than a coincidence, as many analysts fear a possible downturn in the UK property market that could be made worse by Brexit. Indeed, housebuilders’ high borrowings in the run-up to the 2008 financial crisis meant they were among those companies hardest hit by the crash.

The case of British American Tobacco is a good example of how corporate events such as takeovers can dramatically change a company’s capital structure. The tobacco giant recently completed the largest ever purchase of a tobacco company – and one of the biggest merger and acquisition (M&A) deals in history – making it the most indebted company on the market, with £45.4bn of net debt. It bought fellow tobacco business Reynolds America in a £41.8bn deal that saw it take on around $15bn of debt in addition to what it already owed. The remainder of the deal was funded through issuing new shares. This new equity helps to balance out the company’s overall debt-to-equity ratio and back up the borrowings.

The collapse in the oil price around 2015 has made oil and gas the sector that’s increased its debt levels at the fastest rate. Net debt across the sector is up more than fourfold over the past decade, concentrated mainly between oil giants BP (BP.) and Royal Dutch Shell (RDSA). Both these companies feature on our Income Majors list (see IC 13 July 2018) for their high payout ratio compared with other listed peers. Given this context, it shouldn’t be surprising that shareholders had become accustomed to their generous dividends. The oil price collapse meant that payments could no longer be wholly funded through cash generation, so the oil giants were faced with the conundrum of taking on additional debt to fund the payments or cut the dividend and lose shareholder confidence. They opted for the former. Over a three-year period, Shell paid £31bn in dividends while it generated £15bn in net profits, according to Link. Over that same timeframe, its net debt increased by £35bn, but it is worth noting that this includes debt it inherited when it bought BG Group in 2016.

Telecoms and the retail and consumer services sectors are the only ones to have less debt now than they did a decade ago. For the retailers in particular, lower debt is likely to be strategic. Concerns about the spending habits of Britons has high-street stores getting defensive. Even household names such as Tesco (TSCO) and J Sainsbury (SBRY) have all paid down their borrowings in recent years. However, investors in the sector should be wary of the high lease obligations – essentially, off-balance-sheet debt – that many retailers are exposed to.

Red flag or green flag?

The optimal capital structure – the ideal split between debt and equity – can vary dramatically across sectors. What works for a retailer might not be the best funding structure for a utilities company. Before buying shares investors should consider the debt profile of a company and compare it with other comparable companies in the sector.

Debt only becomes a problem when companies cannot keep up with payment commitments. If borrowings are not properly covered, then a potential slide into financial distress should be a concern for shareholders. Some of the most common metrics used to assess whether debt should be a concern or not compare a company’s debt level to that of its equity, assets and interest payment coverage. Such measures give an idea of whether a company has overstretched itself on borrowing commitments, or if it’s in safe territory. From this we can begin to determine the company’s financial risk.

Dividing a company’s net debt by its equity tells us how highly geared the company is, or its leverage. It compares the value of a company’s debt with the value of its stock to show how much the company is borrowing to increase its value or fund projects. Debt can be used to generate higher earnings so long as it is invested in value-enhancing projects, but shareholders may rightfully grow concerned if the amount of debt creeps up towards the value of equity, since shareholders would be the last to get paid if the company were to go bust.

Ahead of the financial crisis, the collective UK public market had an average debt-to-equity ratio of 89 per cent, as total debt of £402bn neared the total value of equity, according to Link. Looking at the average across the whole market, gearing was closer to 137 per cent. This suggests that companies whose market capitalisation was in the middle to smaller range of the market were, comparatively, much more highly leveraged than their large-cap counterparts. This was especially concerning since lenders tend to sway towards the “too big to fail” mentality, and favour providing credit to those big companies they feel have more staying power than those smaller, more vulnerable companies. In the years following, companies had paid down some debt so that the collective debt ratio was 64 per cent by 2012, but it increased to 83 per cent by 2016. Today that ratio sits at around 73 per cent, because although debt is at record highs, equity has also been on the rise as profits have recovered from the crisis years.

Comparing a company’s debt to its assets can also give investors an idea of financial leverage, or how much debt is too much debt. This ratio is of particular interest to creditors since it shows what’s backing up the borrowings – that is, if the company were to fall into financial distress and had to sell off its assets, would it be able to sell them for enough to cover its debt obligations?

According to Link, the average debt-to-assets ratio across the UK public market is currently around 27 per cent, suggesting that the record high debt levels are well backed by assets – although this is not too far off the pre-financial crisis level of 29 per cent. Just after the crisis the focus on debt repayment meant that this ratio fell to around 24 per cent after the credit crunch, but then rose sharply again after a wave of asset write-downs, and debt levels increased to keep up with corporate investment plans and dividend payout policies. 

Some types of companies are better placed to handle high levels of debt than others if they have a lot of assets on their balance sheet. Pub groups are a good example of this. At the beginning of the year Marston’s (MARS) net-debt to cash-profits ratio was around a whopping 6.2 times. This might look unsettlingly high, but take out the cost of leases on some of its pub locations and net debt falls to a more palatable 4.7 times cash profits with 2.6 times fixed charge cover.

There are some common characteristics that allow some companies to sustain higher leverage than others. Those with highly predictable and sustainable cash flows are best placed to service high levels of debt compared to equity. Companies with a lot of physical assets are also better prepared to take on large amounts of debt. Creditors like to know that cash flow will be able to keep pace with interest payments on the borrowings, while the assets are there to be claimed if the company has to liquidate.

Utility companies are a good example in the sense of both debt-to-equity and debt-to-assets ratios. They tend to have steady cash flow streams, since we all need to use water and electricity. Our dependence on such services makes income for these companies fairly easy to predict, and creditors like this predictability. Companies in this sector also have a large asset base in order to be able to supply such basic necessities. Barriers to entry are also high, making it difficult for new entrants to present competition.

At the other end of the spectrum are companies with assets of the more intangible variety. Things such as patents, brands or intellectual property are no doubt valuable to a business, but it’s more difficult to assign a specific value to such assets – especially if they are one of a kind – than it is to something that’s tangible, such as property or hardware. Understandably, the nature of the asset base might make creditors nervous about lending to companies with difficult-to-value assets. Assets with a questionable price tag could be difficult to sell if the company were to get into financial difficulty. The information technology (IT) sector is a prime demonstration of intangible assets. Between 2010 and 2013 the IT sector was the only one to maintain a net cash position on its balance sheet.

The current preference for longer-term debt means that companies don’t need to be so concerned about making the debt repayment in full quite yet. What they do need to worry about is keeping up with interest payments until the lump sum is due. This is why it is important to consider a company’s interest cover before investing. This tells shareholders and creditors how comfortably a company can meet the interest payments on its debt.

Another common metric used is the ratio of interest payments to operating profit, being earnings before interest and tax are paid. From every £8 made in operating profit, around £1 of this goes to paying interest on debt, according to Link’s averaged data across the UK public market. This is a step change from the level seen this time last year, when around £1 in every £5.70 of operating profit went towards interest payments. This change was largely driven by a recovery in corporate profits across the market last year. But as the Bank of England continues to toy with the idea of another interest rate rise, this ratio could creep back up again as debt becomes a more expensive funding option.

Taking on debt can be a tax-efficient, low-cost way for companies to finance their activities. But not all corporate debt is created equal, nor is it as viable for all companies. Those that operate in volatile markets, where cash flow streams are less certain, may want to stick to a net cash position on the balance sheet. Those whose income streams are more steady, and those with the assets to act as collateral, may be in a better position to increase their borrowings. Before buying shares in a company, investors must consider the nature of the business and its cash flows, and whether that debt funding has been put to good use. Debt may have a tricky relationship with the market, but it is certainly not always a black mark on a company’s balance sheet.

Screening for quality

When companies go to debt markets for funding, bondholders impose covenants on management to run the company in a manner that will ensure its safety as a going concern. Typically, these will include restrictions on further gearing and stipulations on the company’s future performance against financial ratios, assessing solvency and profitability.

Breaching debt covenants is obviously a very bad sign for shareholders. In the worst-case scenario, if a company goes bust, debt is senior to equity in the capital structure. Assets that can be salvaged will be sold off to repay bondholders before any leftovers can be divided among those who had equity in the company. Even if the situation isn’t terminal, penalties for breaking covenants can include fines or concessions, which eat into shareholders’ returns.

Despite these risks, debt isn’t bad. With the caveat of prudence, enterprising and effective management should be making use of whatever sources of funding are cheapest to help grow the business and free up cash to fund dividends to shareholders. Flipping the purpose of debt covenants, some of the metrics commonly used can be used positively to highlight quality companies that have an efficient capital structure. The ratios can also point investors in the direction of questions they need to ask in assessing the company’s growth prospects and the security of its dividend.

One of the first things to look at is debt as a proportion of equity. This is total liabilities divided by the value of total equity (ordinary shareholders, preference shares and minority interests) and shows how dependent a company is on debt for its funding. A distinction needs to be drawn between high current liabilities and companies that have made the decision to fund their enterprise with long-term debt, which is a non-current liability. There is the possibility that high current liabilities represent a solvency risk, but that will depend on working capital cycles and how cash-generative a business is. High current liabilities can simply be indicative of normal working capital positions – for example, supermarkets’ trade payables (the money owed to suppliers) will be high.

Focusing on companies that use debt as an integral part of their long-term funding, solvency ratios are still an important part of the mix; being comfortable meeting obligations as they arise means there is less impediment to investing in the business or returning cash to shareholders. Some of the most important measures commonly looked at by bond covenants relate to cash profits, using Ebitda (earnings before interest, taxation, depreciation and amortisation).

Separating a business’s total interest-bearing debt from all liabilities and assessing this figure (net of cash and short-term investments) as a multiple of cash profits shows how long it would take to pay off debts if the two figures were to remain constant. This is an important indicator because it demonstrates how easily a company could change its capital structure in the future. In our examples (see table above), we have chosen to look at companies in different sectors that use debt as a significant part of their funding. Amongst consumer staples companies we can see that Diageo (DGE), with net debt of just over twice Ebitda, could probably quite comfortably adjust its capital structure over the coming years as interest rates rise and debt gets relatively more expensive. Comparing the two tobacco companies, we can see that British American Tobacco (BATS) is geared to almost twice the extent of Imperial Brands (IMB).

The level of gearing is important for income stocks as debt obligations have first dibs on cash flows so represent a threat to dividends. Where there aren’t significant prospects of growing cash flows organically, and there must be doubts about the long-term growth of the tobacco industry, then questions must be asked about the sustainability of highly leveraged companies’ dividends. In the immediate term, another ratio for looking at how comfortable a company is with its debt obligation is interest cover. This is operating profits (Ebit) divided by the interest expense on debt or it can be calculated using cash profits. Using the latter method, we can see that, although BATS is more heavily geared than IMB, the cost of servicing its debt as a proportion of Ebitda is the same. This could be because more of its debt was issued at lower interest rates, while the company recently took advantage of the low cost of finance to help fund its acquisition of Reynolds. This earnings-accretive deal is an example that rising debt needn’t be a red flag, although the point about watching gearing in industries with limited organic growth potential still stands.  

Utilities companies are highly geared on the Net Debt/Ebitda measure and although cash profits cover interest payments, the multiples of four to five times aren’t overly impressive for businesses where the investment case rests largely on the dividend. It would be easy to dismiss these measures, thanks to the safety of future cash flows, but there are other considerations, such as capital expenditure. 

The fixed-charge coverage ratio takes capex into account (and tax expenses/credits) as well as interest expense. How well the sum of these fixed charges is covered by Ebitda gives a better appreciation of cash that’s free to potentially distribute to shareholders. Bear in mind that these are businesses under intense regulatory scrutiny, and any forced increases to capex, in combination with debt obligations, would place dividends under pressure.

In the capital-intensive oil & gas industry, most companies outside of the supermajors don’t pay dividends. The fixed-charge coverage shows how well cash profits are covering capex while meeting their debt obligations. In several cases, the generous tax credits granted to exploration companies when they post an operating loss makes all the difference in keeping this ratio above one. Assessing working capital positions as well as interest cover are important in the investment case for these companies and net debt to assets is a metric to look at in assessing how the company is utilising the capital it has raised.

Regardless of capital structure, in whatever industry a company operates, investors will want to see an upward trend in return on capital employed (ROCE). This measure, which shows operating profit as a multiple of equity and debt funding, helps judge the performance of management. The sustainability and likely rate of growth of profits, as ever, is a crucial consideration but when looked at with measures designed to assess solvency and the level of financial gearing, this analytical approach can at least provide an initial framework to explore an investment case.

Screening for red flags

Screens are useful, but are also best regarded as a rather crude starting point. For a screen to generate results it can’t afford to be too exacting, which means there will always be false positives as well as interesting situations that slip through the net. However, screens for red flags can be a good starting point to try to identify situations that should be given more attention. We’ve looked at two classic screens that can be used to highlight potential balance sheet risk. 

Dangerous Altman Z-Score: Bankruptcy risk

American finance professor Edward Altman is an academic who has put a number on bankruptcy risk. His Altman Z-Score attempts to identify the probability that a company could become insolvent based on the historic relationship between five financial ratios and companies that go bust. His methodology has stood the test of time since he first revealed his Z-Score in 1968. Originally the measure of bankruptcy risk focused on manufacturing companies; however he later published a variant on the formula to cover non-manufacturing companies using four ratios, compared with the five used in the original model.

The five ratios used in Mr Altman’s original Z-Score are: working capital/total assets; retained earnings/total assets; earnings before interest and tax/total assets; market value of equity/total liabilities; sales total assets. Each one of the factors is given a weighting based on their historic significance. An Altman Z-Score of 3 or more is generally considered to indicate a company that is relatively safe, while scores of 1.8 or below are considered dangerous. Below is a list of FTSE All-Share companies with Altman Z-Scores in the insolvency danger zone.

Low F-Score: Deteriorating fundamentals

The F-Score developed by accountancy professor Joseph Piotroski is most commonly associated with the hunt for value stocks with improving fortunes. However, Mr Piotroski’s 2000 paper ‘The Use of Historical Financial Statement Information to Separate Winners from Losers’ also demonstrated that the F-Score could be used to identify future losers by looking for highly rated shares of companies with a low score.

While the F-score is not singularly focused on debt or bankruptcy risk, it does take into account a company’s financing needs. Indeed, the nine factors that make up the F-score are an interplay of fundamental trends that suggest in the case of a high F-Score that a company’s performance is improving without recourse to external financing, or in the case of a low F-Score that performance is deteriorating while the company is drawing on external financing. Mr Piotroski considers an F-Score of 2 or less to be low.

Mr Piotroski used the classic price-to-book measure of value in his original research. Not many companies have a low F-Score and shares with an above-average P/BV ratio. Those that do are highlighted in the accompanying table of low F-Score stocks and many of those highlighted are Aim tiddlers.