9
Financial strength
This chapter reviews measures of financial strength:
- Interest cover
- Debt to equity ratio
- Leverage
By ‘financial strength’ we mean a company’s ability to withstand operating setbacks. In the previous chapter we looked at the short-term position. The long-term situation is even more important.
Interest cover
This ratio is derived solely from the profit and loss account. It measures a company’s ability to service its borrowings.
The ‘interest’ charge is divided into the ‘EBIT’ figure to give the ‘cover’ expressed as ‘so many times’.
Three factors determine the level of ‘interest cover:
- the operating profit
- the total amount borrowed
- the effective rate of interest.
A highly profitable company can have adequate interest cover even though the balance sheet may appear to show a high level of borrowing.
The level of interest rates in an economy will impinge significantly on this ratio, which may partly explain why low-interest economies seem to accept more highly leveraged balance sheets.
The term ‘financial leverage’ is used to reflect the relationship between profit and the fixed interest charge. A high financial leverage, where interest is a high part of pre-interest profits, is an indicator of risk. A small change in operating profit will have a greatly magnified effect on the return to shareholders. A highly leveraged company does well in boom times, but quickly falls into difficulty in a recession.
We can see in Figure 9.1 that the interest cover for the Example Co. plc is 5.6 times. A prudent value for a company is around 5 times.
‘Debt to equity’ ratio (D/E)
The ‘debt to equity’ ratio is one of the most fundamental measures in corporate finance. It is a great test of the financial strength of a company. Although used universally, it unfortunately turns up under many different names and with different methods of calculation. This causes some confusion which we will try to remove in this chapter.
The purpose of the ratio is to measure the mix of funds in the balance sheet and to make a comparison between those funds that have been supplied by the owners (equity) and those which have been borrowed (debt). This distinction is illustrated in Figure 9.2.
The idea seems a very simple one. Nevertheless difficulties arise in two areas:
- ‘What do we mean by debt?’
- ‘How exactly will we express the calculation?’
We will first consider different meanings given to the term ‘debt’. In Figure 9.3 you will see the three interpretations in common use:
- long-term loans only
- long-term and short-term loans (i.e. all interest-bearing debt)
- long-term loans plus all current liabilities (i.e. total debt).
Note that the first two definitions concentrate on formal interest-bearing debt, i.e. that sourced from banks or other financial institutions. In bank calculations, these are the definitions most commonly used. The final definition includes trade creditors plus all accruals, such as dividends, tax and other miscellaneous amounts.
The reason bank analysts use the more restricted view of debt is understandable. Their claims usually rank ahead of trade and other creditors. From the banks’ point of view, the only debt that matters is that which ranks equal to or ahead of their own position.
However, from the companies’ viewpoint, debt due to a supplier is just as real and as important as that due to a bank. There are therefore good arguments for including all debt in the calculation of the debt to equity ratio.
How to calculate the debt to equity ratio
As stated, one kind of debt is as important as another from a management point of view. For that reason, we will use the broadest definition – long-term loans plus current liabilities – for the remainder of this book. This done, we will examine the various ways in which the ratio can be calculated.
First we should emphasise that it matters little which method of calculation we use. Different methods simply give different numbers that mean the same thing. We can measure length in either inches or centimetres and the different numbers express the same length. Similarly, we can express the relationship between equity and debt in different ways. The true ratio is the same irrespective of how it is expressed.
This point is worth noting. Despite an appearance of dozens of business ratios of all kinds, there are actually a relatively small number of independent financial ratios that are absolutely fundamental. The ‘debt to equity’ ratio is once such ratio.
Figure 9.4 illustrates three methods for expressing the ‘debt to equity’ ratio:
Method 1 – debt over equity
This is the classic approach and it is used widely, i.e. all formal interest-bearing debt is expressed as a ratio to equity. However, from the answer it gives it is often difficult to visualise the total balance sheet.
When a debt to equity value is quoted for a company, then, in the absence of evidence to the contrary, it should be assumed that this method has been adopted.
As opposed to a percentage this is often expressed as a traditional ratio. For Example Co. plc ‘debt over equity’ of 72% could also be expressed as ‘debt to equity’ of 0.72 times.
Method 2 – equity over total funds
An approach that is not so common. The answer is almost the reciprocal of the third method shown below, which is more often encountered.
Method 3 – total debt over total funds
This approach can be the easiest to understand, i.e. all debt in the balance sheet (whether interest-bearing or not) is expressed as a percentage of total funds. The answer shows directly the percentage of the balance sheet funded by debt. It therefore gives an instant picture of the funding side of the total balance sheet.
A hybrid approach
We will return to the debt to equity ratio in Chapter 12 (the corporate valuation model) where we will use a hybrid of the above methods.
The numbers are easily extracted from the most complex set of accounts.
The importance of the debt to equity ratio
We place a lot of emphasis on this ratio because, if it goes wrong, the company has a real long-term problem; one which may become terminal.
The greater the debt, the greater the risk. All debt in the balance sheet gives third parties legal claims on the company. These claims are for interest payments at regular intervals, plus repayment of the principal by the agreed time. The principal is repaid either by periodic instalments or a single lump sum at the end of the loan period.
Therefore when a company raises debt, it takes on a commitment to substantial fixed cash outflows for some time into the future. The company does not have a guaranteed cash inflow over the same period. Indeed the inflow may be most uncertain. A fixed cash outflow combined with an uncertain cash inflow gives rise to financial risk. It follows that the greater the loan, the greater is the risk.
Why, then, do companies take on debt and incur this extra risk? The answer lies in the relative costs. Debt costs less than equity funds. By adding debt to its balance sheet, a company can generally improve its profitability, add to its share price, increase the wealth of its shareholders and develop greater potential for growth.
Debt increases both profit and risk. It is the job of management to maintain a proper balance between the two.
Where should the line be drawn? The increased risk to the equity shareholder that results from debt leverage can rarely be forgotten altogether even though some companies do just that. Most companies must take a view on the degree of uncertainty of future cash receipts and arrange their level of debt in line with this uncertainty.
Companies in business sectors with very predictable income streams, e.g. property leasing, usually incur high levels of debt. Companies in highly volatile sectors, e.g. mine exploration, usually fund mainly from equity.
Variations in the levels of debt will also occur across countries and according to the state of the economy. Much has been written exploring the reasons for these variations. The general conclusion seems to be that they arise because of attitudinal, cultural and historical, rather than financial, factors.
Leverage
It is interesting to consider the impact of different debt to equity ratios on shareholders’ returns.
In Figure 9.5, we see a company for which the mix of funds has not yet been decided. (Note: This is a different example to the illustrative ‘Example Co. plc’ we are using elsewhere in this book.) It has assets of $100,000, sales of $120,000 and an operating profit of $15,000. The effects of different levels of gearing or leverage on the shareholders are illustrated in Figures 9.6 and 9.7. (Note: For simplicity, tax is ignored and the interest rate is set at 10%.)
In Figure 9.6 just one level of leverage is analysed to illustrate how the figures work. Option 1 in the first row illustrates a situation with $100,000 equity and no debt. Accordingly there is no interest charge. The total profit of $15,000 is applied to the shareholders’ investment of $100,000. The ROE is 15%.
In the second row, the funding mix has changed to $80,000 equity and $20,000 debt. The interest charge at 10% is $2,000. This is deducted from the profit of $15,000 to leave $13,000 for the shareholders. Because the equity investment is now $80,000 the ROE is 16.25% ($13,00/$80,000 × 100).
As a result of introducing 20% debt into the company, the ROE has increased from 15% to 16.25%. This is financial leverage in action.
In Figure 9.7, the leverage has been extended in steps all the way up to 90%. With each additional slice of debt, the ROE increases until it reaches 60% at the 90% level of debt. Extraordinarily high levels of return can thus be achieved from very highly leveraged companies. The price that is paid for these high returns is the additional exposure to risk.
Summary
The debt/equity or leverage decision is one of great importance to management. There is a risk–return trade-off. The impulse to achieve high returns for the shareholders must be restrained by the company’s risk profile. Even a very well managed company can suffer an unexpected deterioration in its financial position either from a default on the part of a major debtor or a general worsening of business conditions. It can be very difficult to recover from such a deterioration. It is prudent to balance leverage and to keep some liquidity in reserve to guard against such an eventuality.