Chapter 7: Debt and Solvency Checks

Introduction

THE BALANCE SHEET is an important consideration when investing in a company because it reflects what the company owns (assets) and owes (liabilities). It provides a snapshot of how much debt the company has, whether the company might experience financial distress and the funds it generates. This chapter discusses how to assess whether debt is manageable and ensure that the company is solvent.

Debt levels

Companies with high levels of debt are a concern for investors because there is the danger that the company has borrowed too much and will struggle to make repayments, or at least have to redirect cash that would otherwise have gone into growing the business.

A commonly cited reason for dividend cuts is the need to redirect cash to improve the position of the balance sheet, which is code for having too much debt. You will want to check that the level of debt for each company is not too high, which could cause future financial problems for the company.

Net borrowing

Net borrowing (or net debt) is the total amount of money borrowed for financing activities. This can include short- and long-term notes, as well as other payable accounts. Net borrowing is total debt minus cash and cash equivalents. The amount shows the outstanding debt the company would owe if all available cash was used to pay debts owed.

Examining the changes in net borrowing helps to understand how a business is performing financially. If net borrowing is increasing it could be a warning sign that the company is in a poor financial position, as debt is increasing relative to cash holdings. Conversely, falling net borrowing could indicate an improving financial position as debt is being paid off.

Net borrowing to EBITDA

Earnings before interest, taxes, depreciation and amortisation (EBITDA) is net profits with interest, taxes, depreciation and amortisation added back to it. It is a useful measure of earnings as it eliminates the effects of financing and accounting decisions.

The net borrowing to EBITDA ratio is a measure of leverage. It is defined as net borrowing divided by EBITDA. The ratio shows how many years it would take for a company to pay back its debt if net borrowing and EBITDA are held constant.

Morningstar has historic data on net borrowing and EBITDA on the balance sheet or income statement located in the financial section of the company profile. You can use this information to calculate the historic net borrowing to EBITDA ratios over time and examine the trend.

Companies that have net borrowing to EBITDA ratios that are trending above 2 should generally be avoided. If current net borrowing to EBITDA ratios are above 4 then the company is overburdened by debt and should be excluded from consideration.

Example

Table 7.1 shows net borrowing for XP Power has been on a declining trend since 2008 and moved into a net positive cash position in 2014 (indicated by a negative net borrowing figure). Since then, the net borrowing/EBITDA ratio has remained low, a positive for XP Power.

Table 7.1 Net borrowing/EBITDA calculation – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Net Borrowing (£m)

27.8

18.7

18.4

18.6

10.6

3.5

-1.6

3.7

-4.1

8.8

EBITDA (£m)

10.0

11.2

21.6

27.5

23.4

26.2

27.1

29.5

32.1

38.6

Net Borrowing/EBITDA

2.8

1.7

0.9

0.7

0.5

0.1

-0.1

0.1

-0.1

0.2

EV/EBITDA

Enterprise value (EV) reflects the claim on a company from both its equity holders and the owners of its debt. This provides a fuller picture of the value being put on a company compared with market capitalisation, which just looks at the claim from its equity holders. It is calculated by adding market capitalisation to net borrowing (which is total debt minus cash).

The EV/EBITDA ratio shows how many years it would take for a company to buy the claims on the company if EV and EBITDA (cash profits) are held constant. It is defined as EV divided by EBITDA.

Investors should prefer a company with an EV/EBITDA ratio below 12. Any ratio above this will signal that the company offers poor value. If the ratio is above 25 then the company is likely to be very expensive and should not be invested in.

The current EV/EBITDA ratio can also be compared against the historic trend. If the current EV/EBITDA is well above trend, it may be sensible to avoid investing in the company until its share price falls sufficiently.

Example

Table 7.2 shows the EV/EBITDA ratios for XP Power. The company’s current EV/EBITDA ratio is 9.2, which is below 12, and the historic EV/EBITDA ratio ranges from 5.3 to 17.3 from 2008 to 2017.

XP Power’s valuation gradually became more expensive in 2017, with the EV/EBITDA ratio reaching 17.3 at the end of December. This would have prohibited an investment in the company at the end of 2017 or the first half of 2018. However, a subsequent fall in the share price over the second half of 2018 means that the shares are no longer prohibitively expensive.

Table 7.2 EV/ EBITDA ratios – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

EBITDA (£m)

10.0

11.2

21.6

27.5

23.4

26.2

27.1

29.5

32.1

38.6

Market Capitalisation (£m)

25.4

85.6

200.5

179.9

194.1

305.8

269.0

279.4

334.0

659.8

Net Borrowing (£m)

27.8

18.7

18.4

18.6

10.6

3.5

-1.6

3.7

-4.1

8.8

Enterprise Value (£m)

53.2

104.3

218.9

198.5

204.7

309.3

267.4

283.1

329.9

668.6

EV/EBITDA

5.3

9.3

10.1

7.2

8.7

11.8

9.9

9.6

10.3

17.3

Net gearing

Net gearing is another measure of a company’s financial leverage. It is defined as net borrowings divided by shareholder equity (where shareholder equity is total assets minus total liabilities). Morningstar provides historic data to calculate net gearing on the balance sheet, which can be found in the financial section of the company profile.

If net gearing is trending above two thirds, investing in the company should be considered with caution as debt is a high proportion of shareholder equity. In this case, a careful assessment of debt in the industry the company belongs to should be made.

For example, many utility companies have high levels of debt with net gearing above 75%, which is generally viewed as acceptable given the large value of assets they hold and their ability to generate a reliable income from their captive customer base. Therefore, higher debt levels may be acceptable in some instances, such as utilities. In general though, companies with net gearing above two thirds should be excluded from consideration.

Examle

Net gearing for XP Power is shown in table 7.3. Net gearing has been gradually declining since 2008 and turned negative in 2014, indicating that XP Power can pay all outstanding debt and still have cash left over. Borrowing increased in 2017 to fund an acquisition, but net gearing remains low.

Table 7.3 Net gearing – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Net Borrowing (£m)

27.8

18.7

18.4

18.6

10.6

3.5

-1.6

3.7

-4.1

8.8

Shareholder Equity (£m)

28.8

29.6

42.6

55.6

61.1

69.2

80.2

88.3

106.1

116.0

Net Gearing (%)

96.5

63.2

43.2

33.5

17.3

5.1

-2.0

4.2

-3.9

7.6

If gearing is high, look at short-term debt as a proportion of total debt. If the ratio is high, it is a warning signal that a large proportion of debt is coming due for payment and that debt covenants will need to be re-negotiated or paid off with a new loan. The uncertainty over substantial debt can lead to a sell-off in the company, causing the share price to collapse. The short-term viability of the company also needs to be questioned.

The Morningstar website provides figures on total borrowing (i.e., total debt) and a breakdown of when that debt becomes due on the balance sheet.

Example

Table 7.4 shows total debt for XP Power and debt due to be paid within the next year. Total debt peaked in 2008 and has been paid down to low levels. Total debt for 2017 stands at £24m, which is longer term debt taken on to finance an acquisition. This debt is more than manageable given revenues of £166.8m in 2017 and cash profits of £38.6m.

Table 7.4 Total debt – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Total Borrowing (£m)

31.2

22.7

23.4

24.9

14.7

8.5

2.5

8.6

5.5

24.0

Due <1 Year (£m)

7.3

3.9

12.7

13.4

7.3

8.5

2.5

4.0

5.5

0.0

Due <1 Year (%)

23.4

17.2

54.3

53.8

49.7

100.0

100.0

46.5

100.0

0.0

Solvency ratios

Solvency ratios examine whether a company has enough cash and assets to continue operating over the next year without running into financial trouble.

Current ratio

The current ratio measures a company’s ability to meet its short-term obligations. It is defined as current assets (i.e., assets that can be readily converted to cash within 12 months in the normal course of business) divided by current liabilities (i.e., liabilities due within the next 12 months).

Current assets include cash, accounts receivable, inventory, marketable securities, pre-paid expenses and other liquid assets that can be readily converted to cash. The higher the current ratio the better the short-term financial position of the company.

If the ratio is less than 1, it raises concerns over whether the company can meet its short-term obligations, as current liabilities are larger than current assets. However, it doesn’t necessarily mean that the company will go bankrupt. If a company has a low current ratio year after year, it could be a characteristic of the industry it operates in. For example, in the fast-food industry, the inventory turns over much more rapidly than the accounts payable becoming due, so fast-food companies tend to have low current ratios that are below 1.

Morningstar provides a history for the current ratio on the balance sheet in the financial section of the company profile.

If the current ratio is below 1, you should look at the yearly history; if the ratios are persistently below 1, it is likely to be the industry the company operates in rather than a potential solvency issue. This can also be confirmed by comparing the current ratio against companies in the same sector. In general, you should prefer companies with a current ratio above 1 with an improving trend.

Example

Table 7.5 shows solvency ratios for XP Power, including the current ratio. The current ratio has consistently been well above 1 and was a healthy 3.3 in 2017. XP Power can comfortably meet its short-term obligations.

Table 7.5 Solvency ratios – XP Power

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

Current Ratio

1.6

1.7

1.3

1.7

1.9

1.9

2.5

2.7

2.5

3.3

Quick Ratio

0.8

1.0

0.7

0.9

1.0

1.0

1.2

1.3

1.3

1.8

Interest Cover

5.6

10.7

32.8

42.2

42.2

78.3

240.0

254.0

275.0

163.5

Current assets are important to the company because they are used to fund day-to-day operations and pay ongoing expenses. An issue with the current ratio is that it doesn’t make an allowance for how illiquid some of the assets are. For example, if inventory takes a long time to sell or accounts receivable is taking several months for the company to recover on average, then the current ratio may not be a good measure of solvency.

Quick ratio

The quick ratio is a more conservative version of the current ratio. It measures a company’s ability to meet its short-term obligations with its most liquid assets. It excludes inventory, which can be more difficult to sell and turn into cash. It is defined as current assets minus inventory divided by current liabilities.

Like with the current ratio, your preference should be to have a quick ratio above 1 with an improving trend. In addition, a comparison between current and quick ratio is useful; if the current ratio is significantly higher than the quick, it indicates a company’s current assets are dependent on inventory.

Example

Table 7.5 shows the historic quick ratio for XP Power, which has steadily improved since 2010 and been above 1 since 2014. The quick ratio for 2017 is 1.8. As this is lower than the current ratio, it indicates that a large chunk of the current assets are inventory. Since this doesn’t seem to be hampering the company, the quick ratio suggests that XP Power does not have a solvency issue.

Interest cover

Interest cover is a ratio used to determine how easily a company can pay the interest on outstanding debt. It is defined as the company’s earnings before interest and taxes (EBIT) divided by interest expenses. The lower the ratio, the more the company is burdened by debt expense. Morningstar provides a history of interest cover on the balance sheet.

Interest coverage is considered healthy if it is in excess of 3, as the company is able to pay the net interest on its debt for the foreseeable future. If the interest cover is trending below 3, consider removing the company from consideration. When a company’s interest cover is 1.5 or lower, its ability to meet interest expenses is questionable. If it is below 1, the company is having trouble generating enough cash flow to meet interest expenses and could easily fall into bankruptcy if its earnings suffer.

Example

The historic interest cover for XP Power is shown in table 7.5. Interest cover is well above 3 and has been in triple digits since 2014. The interest cover for 2017 currently stands at a very healthy 163.5.

Altman Z-score

The Altman Z-score was explained in detail in chapter 2. It is a model-based indicator about whether (non-financial) companies are likely to become financially distressed. A score below 1.8 means the company has a high probability of becoming distressed, while a score between 1.8 and 3 is a grey area. Our preference is to invest in companies that have an Altman Z-score above 3. Companies with an Altman Z-score below 1.8 are normally excluded from consideration.

Although this statistic doesn’t appear on Morningstar, Stockopedia lists the Altman Z-score for non-financial companies a third of the way down its company profile.

Example

Looking up XP Power’s Altman Z-score on Stockopedia, we find it has a healthy score of 9.9. This indicates that there is little chance of the company going bankrupt.

Piotroski F-score

The Piotroski F-score was also covered in detail in chapter 2. The Piotroski F-score is designed to measure the financial strength of a company using available data from financial statements. Scores range from 0 to 9, with a higher score indicating better financial health. Normally a Piotroski F-score above 7 is preferred, but in some circumstances a score of 6 or more, such as for larger blue-chip companies, may be acceptable. A score of 3 or less should result in a company being removed from consideration.

Stockopedia lists the Piotroski F-score on its company profile. The nine financial tests used to build the score are also available, so you can see which tests were failed and by how much.

Example

Table 7.5 shows XP Power has a Piotroski F-score of 6, indicating that the company’s financial health is improving.

Summary

Key debt and solvency checks are summarised as follows:

Debt checks

· Net borrowing trend is stable or falling.

· Net borrowing to EBITDA is below 2 and on an improving or stable trend.

· Company net gearing is either less than 75% or less than sector competitors’ net gearing.

· EV/EBITDA is below 12.

Solvency checks

· Current ratio and quick ratio are above 1.

· Interest cover is above 3 and the yearly trend is stable or improving.

· The Altman Z-score is above 3, indicating that the company has a low probability of bankruptcy.

· Piotroski F-score is above or equal to 6, indicating that the company’s balance sheet is broadly improving.

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