To most value investors, debt is one of the first things they look at when analysing a company.  Since value investing, almost by definition, involves buying unpopular stocks, there is often some kind of bad news surrounding the company which will only be made worse by high levels of debt.

The problem with debt

Debt, in itself, is not a bad thing and is vital to almost every company in some way or other.  Some debts are short term and interest free, such as credit from suppliers, while other debts are longer term and do incur interest.  In most cases it is the interest bearing debts that are the danger, although in some cases a sudden reduction of incoming cash can cause a cash flow crisis where suppliers cannot be paid.

Debt and the turnaround situation

I used to invest in small and struggling turnaround situations and for these companies debt was a major worry.  Although these stocks can often be picked up at ‘bargain’ prices and sold for big profits at a later date, the risks posed by debt are substantial.

For small and struggling companies the current and quick ratios are a good place to start.

The current ratio is the ratio of current assets to current liabilities.  There are no hard and fast rules but many value investors prefer a ratio of 2 or more in order to ensure sufficient short term liquidity.  This can be a rather limiting rule that is only really suitable for turnarounds rather than solid, healthy companies.

The quick ratio is the ratio of quick assets – those which can be turned to cash within 30 days or so – to current liabilities.  An alternative to working out the true quick assets is to remove inventory from current assets and use that figure.  The idea is that often inventory cannot be turned in to cash quickly and would be of no use in generating cash during a cash crisis.  A quick ratio of more than 1 is enough to keep most value investors happy although again, this can be limiting if applied to healthy companies.

Debt and the wonderful company

I no longer invest in small and struggling companies and instead much prefer the advice of Warren Buffett who said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.  With these ‘wonderful’ companies, debt is usually much less of an issue and most of the time I pay little attention to the current and quick ratios.  For a company which is currently highly profitable and cash generative, they are not particularly important.

For the ‘wonderful’ companies, the level of long term interest bearing debt is more important – although long term debt is important for the turnaround companies too.

One way to measure long term debt is with something called gearing, which has various definitions but I tend to use the ratio between net debt (interest bearing debts minus cash equivalents) and shareholder equity.  Many value investors are only interested in companies where gearing is below 100% and this is certainly a measure I used to use, although I preferred tangible gearing which ignores intangible assets when calculating shareholder equity.

Gearing does have its problems though

Take Imperial Tobacco for example.  It has gearing of around 150%, putting it outside of the old 100% maximum rule.  But is that really too much debt for the company to handle?  Has that debt held them back in the past and does it constitute a risk to the company’s survival?

It certainly doesn’t seem to have held them back.  Revenue, earnings and dividends have all grown by more than 200% in the last decade, while gearing has been up to and over 5,000%.  This shows how gearing can be skewed into absurdity by the capital structure of a business.

As for constituting a risk to the company’s future, the interest cover on the debt is over 7, which is the ratio of operating profits to interest.  This means that only 1/7th of this year’s profits are being used to pay interest. An interest cover of less than 5 is considered too low by many investors, so 7 is quite low but certainly not dangerous for a company with such stable and recession proof earnings as Imperial Tobacco.  Even in the unlikely event that earnings fell to half their current level for the foreseeable future, the interest would still be covered more than three times over.

Another check on the sustainability of debt is to look at the ratio of interest bearing debt to operating profits.  If debts are more than 5 times operating profits then that may become a problem if earnings come under pressure at some time in the future.  For Imperial Tobacco the debts are less than four times the latest operating profits, which means that the debt does not look excessive even though gearing is 150%.

Debt is a risk good companies don’t need

Debt is often used as a way to grow a company quickly, without regard for its long term robustness and sustainability.  When a company has high debts, not only is it a riskier proposition but it may also be telling you something about the priorities of the management (i.e. to grow fast, look good, get on the cover of magazines and win awards – at least for a while).

Equally, if a company has few debts it may be telling you something else about the quality of the business.  As Warren Buffet has often said, “really good businesses usually don’t need to borrow”.

As a value investor, debt is the risk you don’t need to take.