Measuring and avoiding excessive debts

How debt can affect a company’s risk and returns

Here’s an example of how risk is affected by a company’s funding arrangements:

The lesson from this example is that when things are going well, debt can boost returns; but when events take a turn for the worse, too much debt can quickly turn profits into losses.

And it gets worse.

If the example company didn’t have enough cash to pay the debt interest in full, the bank may be able to ask for the entire £ 1m loan back immediately. That would mean either having to sell the factory in a hurry (and potentially at a lower price than the £1m it cost to build it), or the company could ask shareholders for additional equity funds via a rights issue to pay back the debt. And if shareholders refused to put up additional funds then the company could be insolvent, at which point the bank could force the company into administration in an attempt to get its money back.

One reasonable response to this risk is to only invest in companies with no debt at all, but I think that’s excessive. What I’m after is companies that are conservatively financed, and this week we’ll cover some methods for finding those companies.

As we’ve seen in previous weeks, there are three primary funding sources: equity, borrowings and leases. Equity is a low-risk funding source because dividends are optional and the capital never has to be repaid, so here we’ll focus on borrowings and leases.

Conservative borrowings

For the sort of relatively defensive and successful companies I’m interested in, the meaning of conservative financing basically comes down to the size of its financial obligations in terms of borrowings and lease liabilities.

More specifically, what matter is the company’s ability to pay the fees on those obligations (i.e. interest or rent payments) in good times and bad.

There are lots of ways to do this, but I prefer to look at the ratio of total borrowings and leases (from the latest annual results) to ten-year average earnings. As usual, I’m using ten-year average earnings rather than this year’s earnings because I want to see if the debts are sustainable across the economic cycle, rather than in just the current year (which may be a boom year and not representative of earnings across the cycle). Somewhat predictably, I call this ratio the Debt Ratio.

I do have a rule of thumb associated with the Debt Ratio, but the exact amount of debt I’ll allow depends on whether the company operates in a cyclical or defensive market.

Differences between cyclical and defensive markets

In simple terms, cyclical markets have cycles of boom and bust while defensive markets don’t, or at least they experience these cycles to a much smaller extent. During cyclical booms, companies operating in these markets often see their profits grow rapidly and consistently for a number of years. However, when a boom turns to bust these cyclical profits can shrink dramatically and losses are not uncommon.

Because cyclical company profits are typically more volatile and more uncertain, I have a lower debt ceiling for those companies than I do for their more defensive and predictable cousins.

Given this difference, the first step in analysing a company’s debt burden is to decide whether it operates in a cyclical or defensive market.

Deciding whether a company is defensive or cyclical

Markets can be defined at many levels. You could describe a company as operating in the retail market, but if you wanted to be more specific you might say it’s a food and drug retailer.

The Industry Classification Benchmark (ICB) defines standardised terms for various markets in a hierarchical structure. For example, Retail is a super-sector and Food & Drug Retailers is a sector.

We’re going to use the ICB sector definitions because they’re widely used by data providers and you can find them on the London Stock Exchange website. You can also see a company’s sector on the UK Value Investor stock screen.

Just as importantly, each sector has been defined as cyclical or defensive in the UK Dividend Monitor, a quarterly newsletter outlining dividend developments in the UK market. This makes it easy to work out whether a company is cyclical or defensive, at least according to its sector.

You can see the list of sectors in Table 4.1, and I’ve highlighted (in bold) a handful of sectors that I define as highly cyclical.

Defensive	Cyclical
Aerospace & Defense	Automobiles & Parts
Beverages	Banks
Electricity	Chemicals
Fixed Line Telecommunications	Construction & Materials
Food & Drug Retailers	Electronic & Electrical Equipment
Food Producers	Financial Services
Gas, Water & Multiutilities	Forestry & Paper
Health Care Equipment & Services	General Industrials
Mobile Telecommunications	General Retailers
Nonlife Insurance	Household Goods & Home Construction
Personal Goods	Industrial Engineering
Pharmaceuticals & Biotechnology	Industrial Metals & Mining
Tobacco	Industrial Transportation
	Leisure Goods
	Life Insurance
	Media
	Mining
	Oil & Gas Producers
	Oil Equipment, Services & Distribution
	Real Estate Investment & Services
	Software & Computer Services
	Support Services
	Technology Hardware & Equipment
	Travel & Leisure

For most companies their assigned sector definition is accurate, but in some cases, judgment is required when a company doesn’t neatly fit into the ICB system.

For example, Reckitt Benckiser is a seller of defensive products like soap and detergent (they’re defensive because people keep buying soap even during recessions), but it’s listed in the cyclical Household Goods & Home Construction. In my opinion, Reckitt Benckiser should probably be in the defensive Personal Goods sector along with companies like Unilever.

If you run into this sort of mismatch, just make a note of your opinion on whether the company is cyclical or defensive.

Calculating the Debt Ratio

We now have all the components which go into the Debt Ratio. These are:

• Total borrowings: These are used in the capital employed calculation, so we should already have these written down.
• Lease liabilities: These are also used in the capital employed calculation, so again we should have these already.
• Post-tax profits – Going back ten years. You’ll find these on the income statement or you can calculate them by multiplying EPS (in pounds) by the number of shares outstanding.
• Cyclicality – Based on the company’s ICB sector and Table 4.1. You can find a company’s sector on the London Stock Exchange or from data providers such as SharePad or Morningstar.

The steps for calculating the Debt Ratio are:

Having calculated the Debt Ratio, we can then apply one of the following rules of thumb:

These rules of thumb are not drawn out of thin air.

The limit of five for defensive companies is based on a rule of thumb that Warren Buffett has apparently used in the past. His rule, according to Mary Buffett in her book The New Buffettology, was to look for long-term borrowings to be less than five-times average post-tax profits.

The lower limits for cyclical and highly cyclical sector companies is a more cautious version of the same rule and is based on my own hard-won experience.

Calculating the Debt Ratio is relatively simple so let’s run through the process using some of my recent holdings.

Telecom Plus’s Debt Ratio

Telecom Plus is one of the UK’s leading utility challenger brands. It operates as The Utility Warehouse and offers customers gas, electricity, telecoms and broadband services with the simplicity of a single bill.

It’s listed in the defensive Fixed Line Telecommunications sector, and I think that’s reasonable given the defensive nature of its products (most people will keep paying their phone and electricity bills in a recession).

As a defensive company, Telecom Plus should ideally have a Debt Ratio of less than five, otherwise, I probably wouldn’t consider its debts as conservative unless there were exceptional mitigating reasons.

To calculate the Debt Ratio we need the company’s profit after tax for the last ten years, which is shown in Table 4.2.

Year	Post-tax Profit (£m)
2009	16.2
2010	13.4
2011	20.7
2012	23.5
2013	27.1
2014	27.5
2015	32.3
2016	26.1
2017	30.4
2018	30.5

We’ll also need the company’s 2018 current and non-current borrowings, which are zero and £39.4m respectively. And last but not least we’ll need its 2018 lease liabilities, which totalled £0.1m.

And here’s the calculation:

Telecom Plus’s 2018 Debt Ratio is a relatively low 1.6. That’s far below my maximum of five for defensive sector companies, so at this stage, it seems that Telecom Plus has conservative levels of debt.

WPP’s Debt Ratio

WPP is the world’s leading marketing company. It’s a member of the FTSE 100 and is listed in the cyclical Media sector. As a cyclical sector company, I expect it to have debts that are no more than four times its ten-year average profits.

Table 4.3 shows WPP’s profit after tax for the ten years to 2018. In 2018 it had current borrowings of £1025.1m, non-current borrowings of £5634.8m and lease liabilities of £3628.2m.

Year	Post-tax Profit (£m)
2009	437.1
2010	614.6
2011	865.7
2012	849.4
2013	946.8
2014	1076.7
2015	1160.7
2016	1399.7
2017	1816.7
2018	1063.2

The steps to calculate WPP’s Debt Ratio are:

With a Debt Ratio of 10.1, WPP’s 2018 financial obligations were more than double the amount I’d consider prudent for a cyclical sector company.

If WPP was otherwise uninteresting then I would probably just ignore it for now. However, it had other attractive features, such as consistent growth and above-average profitability, then I might take a closer look to see if management had a plan in place to reduce those debts.

As it turns out, by 2018 management had admitted that debt was excessive and the process of paying down debt by selling off non-core businesses was already underway.

Whether or not you’d invest in that situation would then be a judgement call, based on how special you think the company is and whether you think the debt reduction plan is a good one. This highlights how investing can be, and probably should be, more than just a number-crunching exercise.

Summary

Here’s a summary of my rules of thumb for conservative debts.