Why debt can be dangerous to shareholders

There is nothing wrong with debt per se. Many companies borrow in order to try and grow the business. It is too much debt that is the problem. When companies borrow too much and make bad investments it is the shareholders who can end up footing the bill.

The best way to understand the risk of debt to shareholders is to show how it can have a big impact on the profits made for them. The interest on debt magnifies the changes in shareholder profits resulting from a change in sales. This is known as financial gearing.

Just as a higher gear on a bike means that you can travel further with each turn of the pedals, more debt and more interest has a bigger impact on profits for each percentage change in sales. This is great when things are going well and sales are growing. Not so good when times are tough and sales are falling.

Have a look at the example below.

Let's compare two identical companies with identical amounts of money invested (£1 billion) and both earning £200m in trading profits a year. This gives a return on investment (ROCE) of 20%.

Company A has no debt. Company B has lots of debt. It has chosen to finance its £1 billion of assets with £800m of debt at an interest rate of 10% and £200m of shareholders' equity. Company B therefore has an £80m interest bill to pay every year (10% x £800m).

Looking at Company A first.

Company A turns £1bn of sales into £200m of EBIT and £160m of profit for shareholders after taxation at a rate of 20%. To keep things very simple, I've assumed that the percentage change in sales will feed through to the same percentage change in EBIT just to illustrate financial gearing.

This won't be the same in the real world as companies have operating costs which are fixed and don't change when sales change. This gives rise to something known as operational gearing which means that for a given percentage change in sales there will be a bigger percentage change in trading profits.

The easiest way to spot a company with high operational gearing is to look at the track record of its turnover and trading profits. If you see that profits move up and down a lot over a long period of time that is usually a telling sign. Buying shares in companies with stable profits and profit margins reduces your risk as an investor.

As you can see with the case of company A, with no financial gearing, the change in profits for shareholders mirrors the percentage change in sales. A 20% change in sales leads to a 20% change in profits. Even when sales fall by 20% there is still £128m of profits for shareholders.

How to check out a company's debts

When you are looking at a company's debts there are three things you need to consider:

1. Total borrowings - the amount of money provided by lenders.
2. Pension fund deficit - this is a form of debt in everything but name. If a company was liquidated then the pension fund deficit would have to be made good before shareholders received a penny. Deficits also have to be plugged with extra cash contributions. This is cash that can't be paid out to shareholders as dividends or invested in the business.
3. Hidden debts - operating leases or rents on assets used in a business.

You will find the first two items disclosed on the face of a company's balance sheet classified as liabilities. You'll also find them in SharePad. Total borrowings can be short-term liabilities which are due to be paid within one year, or long-term borrowings which have to be paid after one year. Pension fund deficits are long-term liabilities. (To read more about pension fund deficits click here.)

Hidden debts are not shown on a company's balance sheet. However, the obligation to pay rents on properties or for plant and equipment for a number of years in the future is a significant liability. They will have to be shown on balance sheets from 2019 onwards but don't have to be at the moment. SharePad can estimate the amount of hidden debts that a company has (click here to read more about hidden debts).

Let's look at each of these different types of debts in turn by examining a real company. I am going to use Tesco (LSE:TSCO) to do this.

Below is a screenshot of Tesco's balance sheet taken from SharePad. Its short-term and long term borrowings are clearly shown as is the pension fund liability.

At the bottom of the balance sheet is a supplementary table which shows Tesco's total borrowings and when they are due to be paid back.

It's a good idea to keep an eye on the split between short-term and long-term borrowings. Large debts that are due to be repaid are usually replaced with another loan. If interests rates are rising then a company might have to pay a higher rate than its existing loan which could depress profits. If interest rates are falling, then the interest costs on the new loan might be lower which might boost profits.

Large amounts of debt falling due was a big problem for companies during the financial crisis in 2008. Some were unable to get the amount of money they needed at a reasonable interest rate. It gave investors a stark warning of the risks of a company being financed with debt and is a reason why some investors avoid companies with any debt at all.

Finding the amount of borrowings/debt and pension fund deficits is very straightforward. You now need to try and make sense of them. The first thing you should do is look at the trend of the debt and pension deficit numbers - are they rising or falling?

This is easy to do in SharePad as it has over 20 years of financial data for companies - provided they've been around for that long. Ideally, you should look at financial data over at least 10 years to see what's been going on and whether there is any pattern.

Below we can see that Tesco's total borrowing peaked at just under £16bn in 2009. It then came down significantly but has been rising every year since 2013.

Let's have a look at what's been happening with the pension fund deficit.

As we can see, the deficit has increased from around £1bn to over £3bn in 2016, having been nearly £5bn in 2015. You can also see that the deficit has moved around a lot - in other words it is quite volatile.

Tesco's interim results released in early October 2016 (as I write) reveal that its pension fund deficit has ballooned to £7.1bn. As a rough rule of thumb, pension fund trustees will ask a company to plug a deficit over ten years.

So if you divide the deficit by 10, Tesco will have to make extra top-up payments of around £700m per year to plug the deficit. That's £700m of cash that can't be paid to shareholders. This is why pension fund deficits matter.

In the chart below you can see that its hidden debts (lease & rental commitments) have increased significantly as it has sold a lot of its supermarkets to property companies and rented them back under long-term agreements.

So we can see that Tesco has significant total borrowings, pension fund deficit and hidden debts. It has a lot of debt. But what does this actually mean for an investor?

Measuring how well a company can cope with its debts

So far we have just looked at balance sheet ratios. You can get a measure of how indebted or not a company is by looking at how well its income or profits can cope with costs of debt (interest) and the rents on hidden debts.

Interest cover

The most commonly used ratio is interest cover which tells you how many times a company's trading profits (EBIT) can pay the annual interest bill on its borrowings. Property and utility companies can have low interest cover ratios of 2-3 times and it not be a problem. For other non-financial companies, interest cover of less than 3 times would generally be a cause for concern. Tesco in 2015 and 2016 is a case in point.

Fixed charge cover

This is similar to interest cover, but it also takes into account the rental costs on leased assets which give rise to hidden debts.

Fixed charge cover is very relevant in sectors such as retail or transport when lots of assets are rented (e.g. shops and airlines). A deteriorating fixed charge cover ratio can be a sign of financial difficulties ahead and is something to worry about if it goes below 1.3 times.

Comparing debt ratios across sectors in SharePad

It is very easy to compare debt ratios - or any ratio for that matter - in SharePad. You just add your ratio columns to a list of shares and then select a sector filter. One for Food and Drug retailers in the FTSE 350 index is shown below.

Other things to consider

SharePad can help you thoroughly examine a company's debt position so that you can avoid risky companies. That said, there are other things that you might want to consider as well.

Remember that debt levels on balance sheets are based on a snapshot on one particular day. Companies tend to present their year end balance sheets when they give the most favourable picture of their financial position. Average debt levels can be a lot higher throughout the year.

One way of checking for this is to divide the cash interest paid figure in the cash flow statement with the total borrowings figure on the balance sheet. If the percentage figure is a big number - say more than 10% - then average debt levels are probably higher than year-end levels - the company has more debt than it is showing on its year end balance sheet.

Watch out for special types of creditors which are debt in all but name. For example, housebuilders can have big land creditor liabilities (land bought but not yet paid for) which can increase their debt levels.

To their credit, companies such as Barratt Developments (LSE:BDEV) and others are very up front about this and disclose their land creditor positions in their annual accounts. This figure should be added to total borrowings to get a true picture of their debts.