26 Long-term solvency performance measures

Need to know

Why is this important?

Banks and other providers of debt place demands on a business in the form of regular interest payments and repayment of the outstanding balance.

While debt commits a business to certain future cash outflows, it is unlikely to be able to guarantee its future cash inflows with the same degree of certainty. This imbalance is a cause of financial risk. The more debt (or gearing) a company has, the greater its financial risk. See the Nice to know section below for more detail on financial risk.

Deciding upon an optimum level of gearing is a question of risk versus return. Debt can boost returns as it is usually a more cost-effective form of finance than equity (see Chapter 29 Equity finance and Chapter 30 Debt finance). A lower cost of finance usually results in higher returns and faster growth, which ultimately increases the value of a business.

Gearing

Gearing (or ‘debt to equity’) measures a business’s long-term financing structure. Its purpose is to compare a business’s borrowings (debt) with its funding from shareholders (equity).

There are two common methods of calculating gearing, simplified below:

$\begin{array}{l}\text{Method One: Debt to equity}=\frac{\text{Debt}}{\text{Equity}}\hfill \\ \text{Method Two: Debt to debt + equity}=\frac{\text{Debt}}{\text{Debt + equity}}\hfill \end{array}$

Both methods can be calculated as a traditional ratio or a percentage.

For example, a business with £100 million of debt and £200 million of equity would have a gearing of 0.5 times or 50% under method one. Under method two the same business would have a gearing of 0.33 times or 33%.

Method 2 (debt to debt + equity) is easier to many people to understand as it gives a clear picture of a business’s exposure to debt, in relation to its total funding. It has a maximum of 100%, which is easier to interpret.

The higher the gearing, the riskier the business – in terms of both dilution of earnings to interest payments and sensitivity of earnings to changes in interest rates.

In practice

Management must determine an appropriate level of gearing based on the company’s particular circumstances, the current economic climate and what is acceptable to shareholders.

As a rule of thumb, businesses with more predictable cash flows can absorb higher levels of debt (and gearing) than businesses in more volatile sectors. Additionally. if a business has a high percentage of fixed operating costs. This will impact its ability to take on debt. See ‘operating risk’ in Chapter 33 Profit planning.

In practice gearing levels (debt to debt + equity) for well-established companies will be less than 33% although this will vary from business to business and industry to industry.

Interest cover

Interest cover is a measure of the affordability of debt to a business. The more interest cover a business has, the more affordable its debt and the more ‘headroom’ it has to allow for volatility in earnings.

Interest cover is calculated as follows:

$\text{Interest cover (times)}=\frac{\text{Profit before interest and tax}}{\text{Interest}}$

This ratio indicates how many ‘times’ a business could theoretically afford to pay its interest charges.

The ability to service debt is a measure of risk to debt providers, shareholders and ultimately the business itself.

Interest cover in practice

In practice a business should be able to cover its interest at least two or more times, although this benchmark will vary across business types and industries.

The level of interest cover is affected by:

• ■operating profit
• ■the amount borrowed and
• ■the rate of interest on debt.

The relationship between gearing and interest cover

For most businesses there is an inverse relationship between gearing and interest cover. Management will try and strike an appropriate balance between the two.

Low interest rates will make it easier for businesses to achieve a comfortable level of interest cover and hence lead to higher levels of gearing.

One of the causes of the 2007/8 financial crisis was an unprecedented prior period of low interest rates across the global economy. This encouraged companies, and banks in particular, to accept higher levels of gearing than normal, which left them severely exposed when parts of the financial system began to collapse.

However, the relationship between interest cover and gearing is not always simple, a highly profitable company may have a relatively high and comfortable interest cover, while maintaining a high level of gearing.

Nice to know

Leverage and financial risk

Directly related to gearing is the principle of leverage and financial risk.

Leverage is the utilisation of debt to obtain more finance than would otherwise be possible from using equity finance alone, and hence being able to make a bigger investment than would be the case if only equity finance was used. Businesses use leverage to multiply the returns possible from an investment on the assumption that the investment’s returns are greater than the cost of borrowing.

Leverage is a cause of financial risk or volatility in profit. A high level of gearing usually equates to a high cost of interest. The higher the cost of interest in relation to pre-interest profits (a low interest cover), the higher the financial risk.

For businesses with high leverage, a small percentage change in pre-interest profit will result in a large percentage change in post-interest profits. Thus, these businesses can do very well in times of growth, but struggle, or even fail, when trade declines.

Example

The following example provides an illustration of both financial risk and leverage in practice.

Companies A and B operate in the same type of business and have identical PBITs (profits before interest and tax) of £100,000 p.a. Both companies have £500,000 of financing (equity plus debt). In fact, the only difference between the two companies is their gearing. Company A has 33% gearing (debt to debt + equity) and company B has 67% gearing. Both companies borrow at the same annual rate of interest, being 10%.

The interest charge (which is the same irrespective of the volume of business) is calculated as follows:

• ■Company A: 33% × £500,000 × 10% = £16,500.
• ■Company B: 67% × £500,000 × 10% = £33,500.

The following table considers the impact of a 20% fall in their PBITs on their PBTs (profits before tax).

A 20% change in PBIT leads to a 24% change in PBT for company A and a 30% change for company B.

As company B has higher fixed interest costs, its bottom-line profits are more volatile. However, it can also experience higher percentage growth when profits increase.

It is important to note that the same magnification would apply if profits increased.

To see the full picture, it is useful to consider ROE (return on equity – see Chapter 23 Profitability performance measures for further explanation). Although company A has higher ‘absolute’ profits than company B, it has used double the amount of equity to generate those profits.

Using the following definition of ROE, we can compare the results for both companies. Note, for simplicity this example assumes a tax rate of 0% and therefore, PBT is the same as PAT.

$\text{ROE}=\frac{\text{PAT}}{\text{Equity}}$

The equity is calculated as follows:

• ■Company A: 67% × £500,000 = £335,000
• ■Company B: 33% × £500,000 = £165,000

Therefore, leverage enables company B to always achieve higher returns on equity than company A.

In times of growth, leverage can act as a catalyst and significantly increase returns further still. However, the opposite is true when activity falls. Increased return comes with increased risk, especially to shareholders. This is a trade-off which needs to be carefully considered by management.

Optional detail

Defining ‘debt’?

To calculate gearing ‘debt’ should first be defined.

There are three main definitions used in practice:

• 1long-term loans only
• 2long-term and short-term loans (including any overdrafts)
• 3long-term loans plus current liabilities.

Definitions 1 and 2 include interest-bearing debt, for example bank loans. Therefore, these definitions are generally used by banks and other financial institutions, as they calculate gearing from their perspective.

However, from a business’s perspective, amounts owed to suppliers can be just as relevant as debt due to banks and therefore a business may use definition 3 to calculate gearing. It will also depend on if the business wants to take a long-term or short- to medium-term view of gearing.

Overall, as long as there is a consistent benchmark, the definition of debt is mainly academic. As with other performance indicators, it’s the benchmark that counts.

Reflect and embed your understanding

• 1Is solvency more important than liquidity or are they equally important?
• 2How should a business determine an acceptable level of financial risk and therefore its level of gearing?
• 3Some schools of thought believe there is a debt-equity balance which minimises the overall cost of capital, whereas other schools of thought believe that increasing the level of gearing will always lower the overall cost of capital. Which is more realistic and why?
• 4Choose an example company with long-term debt. Review its disclosed approach to both its level and measurement of gearing. Are they both reasonable?
• 5Choose an example company which discloses other measures of solvency besides gearing and interest cover. What additional information do these measures provide?

For the authors’ reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

• ■Gearing can be derived solely from the balance sheet.
• ■Interest cover can be derived solely from the P&L account.
• ■In both cases it may be helpful to review the supporting notes for clarity.

Extract from Greggs plc 2020 annual report and accounts

Greggs plc is atypical in that historically they have carried no debt other than normal trading liabilities to creditors and obligations arising under commercial leases. In the supporting notes to Greggs plc’s 2019 Annual accounts it noted that Greggs plc’s board does not consider it currently appropriate to take on structural debt, due to the commitments of leasehold shop rents and working capital requirements.

During 2020, as a result of the Covid-19 outbreak, Greggs plc sought debt financing to support its short-term liquidity requirements. These loans were fully repaid by the end of 2020. At the end of 2020 Greggs plc had in place a £100 million revolving credit facility (flexible funds which can be accessed and repaid as required) with a syndicate of commercial banks to ensure a strong financial position going into 2021. At the end of 2020 Greggs plc was net cash positive and had £36.8m of cash on its balance sheet and no drawings on the facility.

At the end of 2020 Greggs plc’s disclosed £291.7m of lease liabilities on its balance sheet.

These liabilities relate to shop lease commitments. International accounting standards (IFRS 16) require all leases to be capitalised and the subsequent liability recognised.

Some analysts may include lease liabilities as part of financial liabilities in their calculations of a company’s net debt and gearing ratio.

(Appendix p. 446)

(See also Chapter 9 Tangible fixed assets and depreciation.)

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 420.

Watch out for in practice

• →Levels of fixed operating costs in the business (operating risk). Unless the business has a healthy interest cover, it is inadvisable to combine high operating risk (see Chapter 33 Profit planning) with high financial risk (gearing).
• →Year-on-year changes in gearing and interest cover.
• →Changes or announced planned changes to capital structure.
• →Redemption dates on debt (i.e. the date that debt must be repaid) and plans to fund the repayment (cash or further debt).
• →The balance of short-term versus long-term debt.
• →Average effective interest rate (sometimes disclosed in the notes to accounts).
• →Levels of gearing and interest cover relative to other companies in the same industry.