In this chapter we introduce the borrowing ratios; further illustrations of these, showing some technical adjustments, are given in Chapter 21.
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Interest cover
When we are looking at a company’s borrowings we are concerned about its ability to pay the interest and repay the loans when they fall due. To see if the company is having any dif- ficulties in paying the interest, we need to look at both the profit and loss account and the cash flow statement.
Interest cover identifies how many times the company can pay the interest out of the available profit or cash. It is simply calculated:
Profit before interest Interest payable
The higher the number the better. Ideally, we would want to see an interest cover falling between four and six times, depending on the risk profile of the company. The riskier the company the more cover we would want to see, as the profits would be more volatile.
Most interest cover ratios are prepared from the profit and loss account, but interest is paid from cash. it is useful to look at the cash interest cover. To do this we need to look at the cash flow statement:
Operational cash flow Interest paid
6 The borrowing ratios
High levels of borrowing and poor interest cover is an indication of possible future sol- vency problems. Looking at companies is just the same as looking at people in real life. In the 1980s banks and building societies were prepared to lend up to four times a couple’s joint salary to buy a house, and people took out enormous mortgages. They were highly geared.
Had they borrowed less, their gearing would have been irrelevant. Their mortgages would have been a smaller percentage of their ‘take-home’ salaries. But many people borrowed the maximum amount that they could, believing that ‘there’s nowt as safe as houses’. For them, being highly geared became theproblem. They had a poor interest cover. Real people expe- rienced exactly the same problems as companies. People’s ‘profits’ fell: they lost bonuses (and some lost jobs), just at the time when interest rates doubled. And there was a limit to the number of lodgers that could fit into a house! For a lot of people it was even worse!
people in southern England had the same problems that the property companies had. Their mortgage payments were larger than their salaries, but they could not sell their house because they would not get enough money back from the sale to repay the loan! Negative equity is not just a domestic problem; it is a corporate problem.
Interest cover is crucial, if you look at the large companies that went into liquidation in the last recession, they were highly geared companies with low interest covers. In fact, you probably do not even need to be highly geared, your borrowings could be relatively low, but you could still have poor interest cover. The important question is, can the company afford to service its debt?
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Sensitivity to interest rates
If we knew the variable interest rates a company was paying (unfortunately we usually do not, and so have to approximate) we could work out the effect that a 1 per cent change in interest rates would have on both earnings and interest cover.
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Gearing
Accountants and analysts use the gearing ratios to quantify the proportion of borrowed cap- ital. Financial gearing is a measure of the amount of debt a company has, and the debt can be expressed as a percentage of either the debt (the old UK accountant’s approach) or the shareholders’ funds (the City of London and banking approach). Alternatively, we could use the net debt as a percentage of shareholders’ funds; this is becoming increasingly popular and is probably the most common definition of gearing.
The different ways of calculating gearing will quantify variants of the same thing.
Accounting gearing
The traditional way of calculating gearing measured long-term loans as a percentage of the long-term capital available to the business. This shows us what percentage of the total long- term capital has been borrowed:
Long-term loans x 100 Capital employed
Gearing calculated in this way will always generate a percentage below one hundred, the City of London’s methods of calculating gearing (see below) can generate percentages way in excess of 100 per cent.
City gearing
This looks at the relationship between long-term debt and the equity (the shareholders’ stake in the business), in the USA it is referred to as leverage. There are three different ways that this can be calculated, using:
● long-term debt
● all debt
● net debt.
These are discussed below.
Long-term debt
This is calculated as follows:
...Long-term loans... x 100
Capital and reserves All debt
This is a measure that is often used by banks and credit rating agencies. it may also be a more appropriate measure when looking at smaller private companies, which have limited access to long-term loans.
...All debt ... x 100 Capital and reserves
Net debt
This is the commonest way of calculating gearing in the City of London. It deducts any cash and short-term deposits from the debt. the total debt is usually the figure used. This tends to be a better measure when looking at multinational companies which may have both cash balances and bank overdrafts. These are often in different countries; with the cash balances in one country and bank overdrafts in another. There are two reasons why this may occur:
● it is very difficult to take cash out of some countries. For this reason, companies may have an overall cash surplus, but are reluctant to use it in a country with these remit- tance restrictions, so they will borrow money in these countries instead of transfer- ring the cash;
● some companies take advantage of interest rate differentials, borrowing money in countries with low interest rates and depositing in countries with high interest rates.
This is discussed in detail in Chapter 13. Whilst this may flatter profits in the short term, it can create problems in the long term. Countries paying higher interest rates are not doing so because they feel generous towards investors! Their economy is viewed as being a less attractive one to invest in, so they have to pay higher rates to attract investors. Companies doing this always run the risk of incurring future exchange losses. If the economy does not perform well, the relative value of the currency will fall.
Or it could simply be that the loans have early redemption penalties, and its cheaper to keep the loans rather than pay them off!
To return to the gearing calculation, gearing on this basis would be:
All interest-bearing debt – cash and short term deposits x 100 Capital and reserves
6 The borrowing ratios
Net debt is probably the most common way of calculating gearing today, but we should select the definition of gearing that seems most appropriate for the company that we are analysing. The way we choose to calculate gearing is largely irrelevant, as long as we are con- sistent in the way that we calculate it – we should still see the same trends. It is important to calculate our own gearing figures, and not to rely on the ones chosen in the company accounts. Finance directors will always pick the most flattering definition, which may change from one set of accounts to the next!
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The leverage effect
It is possible to calculate how sensitive a company’s earnings are to small changes in oper- ating profits. This can be done by calculating the leverage effect. We know that gearing affects earnings. One thing that might be useful to know is the effect that a 1 per cent increase in profit before interest would have on earnings. (This is a similar principle to operational gear- ing, which looked at the change in operating profits from a 1 per cent change in sales.) It is calculated by using the following formula:
Increase in earnings from a 1% increase in profit before interest x 100 Current total earnings
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Operational gearing
Operational gearing can rarely be calculated from published financial statements, as it requires an analysis of the fixed and variable costs. However, you will find reference to it in brokers’ reports as many analysts try to estimate the fixed and variable cost split. If the infor- mation is available operational gearing may be calculated using the following formula:
...Contribution...
Operating profit
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Combined gearing effect
If we are able to identify the company’s variable costs, it is possible to calculate the impact that changes in sales have on earnings (assuming constant interest and tax rates and no exceptional items) by combining operational gearing and interest cover:
Operational gearing x interest cover
This shows percentage change in earnings arising from a percentage change in sales and is referred to as the combined gearing effect. However, its use probably lies more in the realm of exam questions than practical financial analysis.
Acceptance A bill of exchange whose payment has been guaranteed by a bank.
Bill of exchange A negotiable instrument that is written by the supplier and signed by the cus- tomer in an acknowledgement of the debt.
Bond A negotiable instrument offered for sale to the general public.
Commercial paper A short-term negotiable instrument, often used by large companies as a cheaper alternative to bank overdrafts.
Convertible bond A bond that gives the holder the right to convert their bonds into ordinary shares at a predetermined price.
Debenture A document creating or acknowledging company debt. It is a negotiable instrument and can, therefore, be bought or sold.
Eurobond A bond that is usually issued outside of the country of the currency and has few restric- tions on either its issue or its trading.
Fixed charge This gives the lender a legal right to specified assets that the company cannot sell without the lender’s permission.
Fixed cost A cost that does not increase with the number of units sold. Within certain levels of volume, these costs will not change.
Floating charge A general charge on the company’s assets, usually relating to short-term fixed assets and current assets.
Forward-rate agreement (FRA) An agreement to buy something, at an agreed price, in the future.
They lock companies into a price, and are commonly used to reduce currency and interest rate risks.
Negative pledge A promise, given by a company to its bankers, to get the bank’s permission before taking out any more loans.
Note An unsecured negotiable instrument that can be a source of long- and short-term borrow- ings.
Operational gearing A measure of the percentage change in profit for a 1 per cent change in sales.
Option An opportunity to buy something at an agreed price. Options are available on shares, bonds, currencies, interest rates and futures.
Sinking fund A fund established to repay loans. there are different types of sinking fund:
● traditional fund – this repays the debt at the end of the period and is similar to an endow- ment policy;
● non-cumulative fund – this repays a fixed amount of the borrowings each year;
● cumulative fund – the amount that is redeemed is a fixed amount of cash plus the interest that has been saved by the early redemptions.
Subordinated loan A loan that ranks behind other loans in a liquidation.
Swap An exchange of cash flows, usually interest rates or currencies.
Variable cost A cost that moves in proportion to the number of units sold.
Warrant A type of option that allows the holders to buy shares at an agreed price at a future date.
Yield A measure of the return on the investment.
6 The balance sheet: borrowings JARGON