highly leveraged companies should be a red flag

Low interest rates have shielded many heavily indebted companies from financial difficulties in recent years. Indeed, the rates have been equal to or less than 0.75% for 13 years.

Today, however, a new era of less accommodative monetary policy seems to have begun. The Bank of England has hiked interest rates at its last two meetings, with four of its nine members voting for an even bigger hike than the 0.25 percentage point increase at its last meeting.

Higher borrowing costs could pose serious problems for highly indebted companies. For example, a greater proportion of their profits may be needed to service loans. This can inhibit dividend growth and mean they fail to reinvest in long-term growth opportunities. As a result, the price outlook for their shares could be harmed.

According to Questor, assessing the financial condition of companies will become increasingly important in the years to come. Obviously, accurately predicting rising interest rates is a “known unknown”. But, as the pandemic recedes and inflation remains well above target, further interest rate hikes seem inevitable.

The debt ratio is a simple way to assess a company’s financial leverage. It compares a company’s borrowings to equity and provides insight into its reliance on debt to fund its operations. The ratio is calculated by dividing total debt by equity, both of which appear on the balance sheet.

For example, the recent peak BHP has total debt of around £15.5 billion and equity of £41.2 billion. This gives a leverage ratio of around 0.38. This means that for every pound of equity, BHP uses 0.38 pounds of debt to fund its operations.

Some investors may have specific parameters on what they consider an acceptable debt ratio. For example, they may choose to avoid companies with a ratio greater than one. However, two companies with the same ratio can have very different risk profiles.

For example, BHP’s business is highly dependent on commodity prices which are unpredictable and volatile. In contrast, companies operating in more stable industries, such as utilities or tobacco companies, have much more reliable revenue streams, which means they are able to sustain greater leverage. Therefore, interpreting the debt ratio requires consideration of a company’s operating environment and business model.

Of course, the debt-to-equity ratio is not an infallible measure of a company’s ability to sustain higher interest rates. Indeed, checking how much leeway a company has when making interest payments can provide insight into its performance in an increasingly belligerent monetary policy environment.

The interest coverage ratio indicates how many times a company can afford to pay its debt service costs over a given period. It is calculated by dividing operating profit, also known as earnings before interest and taxes, by interest payments. Both figures can be found on the income statement.

Going back to the previous example, BHP’s operating profit in the 2021 financial year was £19.2 billion. He paid just over £1billion in finance charges, meaning his interest coverage ratio was around 19.

As a result, its earnings could drop significantly, or its finance costs could increase significantly, before it is unable to service existing debt. As with the debt ratio, the stability and reliability of a company’s financial performance will affect what is considered an acceptable ratio by investors.

Undoubtedly, there are other useful metrics that can be used to assess the financial health of a business. However, according to Questor, the debt and interest coverage ratios offer a simple way to quickly assess the financial situation.

Their relevance may have been diluted in recent years as some investors and businesses assumed that low interest rates would persist indefinitely. But their importance, as part of a broader investment checklist, could increase significantly as rising interest rates reveal that companies have failed to manage their finances wisely.

Read Questor’s latest column on telegraph.co.uk every Sunday, Tuesday, Wednesday, Thursday and Friday from 5am.

Read Questor’s investment rules before following our advice.


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John A. Bogar