The current turmoil on world financial markets can largely be attributed to one thing, and that is debt, or more specifically, too much of it. But that isn’t to say that debt is a bad thing. In fact, companies and households were happy to take on mountains of it when the securing assets (mainly property) were continually rising. Put simply, the greater the debt, the greater the leverage, which meant greater returns.
However the power of leverage works both ways and this is something that seems to be too often ignored. Losses are just as easily multiplied and for this reason we need to ensure that debt levels are appropriate and manageable. This is of course an extremely important consideration for companies in an environment of increasing credit costs and falling earnings.
This is not to say that companies should carry as little debt as possible. Debt financing allows companies to pursue opportunities that would otherwise by unachievable, and which could lead to improved earnings down the track. Also, companies (like traders) like to take advantage of debt to leverage their income generating ability. The important thing is that the debt serves a positive purpose and above all is serviceable.
Debt, like earnings, should be viewed in a relative way. We cannot set appropriate levels using a dollar amount, because what is appropriate will be different for each company. Analysts tend to use fundamental ratios such as debt to equity (DE) in this regard, because it benchmarks the debt against the equity of a company.
Debt to Equity Ratio = Total debt / (Total Assets – Total Liabilities) x 100
Currently, the average debt to equity ratio for the Australian market is 40%, but there is of course a lot of variation across sectors. For example, the transport sector has an average DE of 70%, while financials (excluding banks) have an average of just 5%.
When looking to establish what is an appropriate level, comparisons with the sector average is a great place to start, and in many ways better than making a comparison against the market as a whole. This is because different industries have different requirements for debt, and operate under different business models.
A good rule of thumb is to be wary of stocks that have a DE ratio greater than 80%. You can’t automatically say that such companies should be avoided, just that you should be confident that they are capable of servicing their debt. In addressing this there are several considerations. Firstly, you need to evaluate the company’s earnings outlook. After all, debt is serviced from company earnings, so if it looks as though earnings are likely to suffer in the future, it will make the payment of interest and the repayment of capital much more difficult.
Another consideration is the current lending environment. If interest rates and/or other lending costs are increasing, this is going to impact those companies that are highly geared much more than those that are more conservatively leveraged. The current credit crisis is a perfect case in point. Enough said!
Finally, we can more easily tolerate companies with a high gearing level if they are able to easily service their debt. In this regard, another fundamental ratio is very helpful. The interest cover ratio shows how many times over a company can meet its annual interest burden.
Interest Cover = EBIT (pre-tax earnings) / Total interest expense
For this ratio, it’s a case of the higher the better. A company may have a DE ratio of 115%, but if it has an interest cover of 50 we know that servicing the debt is not a problem. In fact, this would be a better alternative than a company with a DE ratio of 5%, but an interest cover of 1.5. Sure, the debt level is low relative to the equity, but the company is barely able to meet interest payments (let alone pay off the principle!).
The average value for interest cover is currently around 5, however it is again better to make comparisons among sector peers. A good rule of thumb is to avoid companies with an interest cover less than 3.
In conclusion, remember that debt is a very useful thing. We just need to ensure that a company is using it in a judicious way, and is able to comfortably service the interest and principle repayments. This is also true for us as individuals, and just as debt can financially cripple someone who has taken on too much, it can also be the undoing of otherwise sound companies. It’s the borrower who needs to be in control of the debt – not the other way around!
Make markets work for you,