How to weigh up a firm's debt
Phil Oakley Jan 24, 2011
One thing you must always remember as a shareholder is this: debtholders get paid before you. That means you need to monitor the level of debt a firm carries, and how it is coping with it. Here we use Tesco's 2010 accounts to show you how to evaluate financial risk. There are four key areas to watch.
1. Interest cover
This measures how easily a firm can afford to pay the interest on its debt. Low interest cover suggests a firm may run into trouble paying its interest bills if profitability falls, which could also put dividend payments at risk. To work it out, add the operating profit to the 'interest receivable' figure, then divide by 'interest payable'. Tesco's operating profit is £3,457m. We subtract £377m of property profits (which may not be ongoing) and add £114m of interest receivable. This leaves £3,194m of profits to pay £531m of debt interest (from note five to the accounts). That gives a relatively healthy interest cover of six times, compared with 7.3 times in 2009 (£2,933m/£400m).
2. Fixed-charge cover
This looks at a firm's ability to pay all its fixed charges. The most common of these are interest payments and operating leases related to fixed assets. This ratio is particularly appropriate in industries such as retail, where many firms rent some, or all, of their stores. You calculate the ratio by adding operating profit to interest receiveable, plus 'operating lease expenses'. Divide this by the operating lease figure added to the interest payable figure. For Tesco the fixed charge cover is 2.9 times – (£3,194m + £927m)/(£531m + £927m) – from 3.2 times in 2009. This is a lower number than the interest cover ratio. It highlights the increased leverage of firms that have large rental expenses.
3. The working capital cycle
Working capital is the excess of current assets (such as stocks and debtors that can be turned into cash within a year) over current liabilities (such as supplier credit that needs to be paid within a year). Having more current assets than liabilities is desirable to a lender. But having too much money tied up in stocks or debtors is wasteful and could be a sign of an inefficient business.
The 'current' ratio (current assets/current liabilities) is commonly used as a measure of liquidity, with a value of 1.5 to 2.0 times seen as desirable. Tesco has a current ratio of 0.73 (£11,765m/ £16,015m). That might look worrying, but in fact it highlights one of Tesco's great financial strengths. What is more revealing is Tesco's working capital cycle. This measures how quickly it turns its stock into cash and how rapidly its debtors pay it, compared with how long it takes to pay its suppliers (trade creditors).
Stock days for Tesco – (stock figure divided by cost of sales)*365 – come in at 23.4 days. Debtor days – (trade debtors/sales)*365 – come in at 7.2. Add those up and you get 30.6. Creditor days meanwhile – (trade creditors/cost of sales)*365 – are 43.7. This means Tesco turns its stock and debtors into cash 13 days before it has to pay its suppliers. Its suppliers are therefore financing its business, allowing Tesco to borrow less – a simple illustration of the power supermarkets have over their suppliers.
4. Debt and hidden debt
Most professional investors focus on a firm's net debt (debt less cash). This can be misleading: not all cash is always available for repaying debt – a customer may have paid in advance, or cash is needed to pay creditors or dividends. It may be more prudent to look at a firm's total debt and compare it with the amount of equity (total debt/equity). Tesco has £13.27bn of total debt compared with £14.7bn of equity – a ratio of 90.2%. That's quite high, but compares well with 2009's figure of 123%. The annual report also tells you the maturity of debt (when it has to be repaid) and whether it is subject to fixed or floating interest rates. Most of Tesco's debt is fixed, so it is not really exposed to rising interest rates. Nor does it have large sums of debt about to mature, and so does not face significant refinancing risks.
Also be aware that companies can move liabilities 'off-balance-sheet'. Tesco has sold a number of its stores to property firms while agreeing to rent them for an agreed term. This is known as 'sale and leaseback'. Tesco gets a cash sum (which is on the balance sheet), but the commitment to pay rent in the future is off-balance-sheet. In substance, these payments are liabilities. So the present value of those payments should really be treated as debt. Credit rating agencies sometimes multiply the annual operating lease expenses figure (£927m as mentioned) by eight to get an estimate of this off-balance-sheet debt – this would give a figure of £7.4bn for Tesco's 2010 accounts. Arguably, its pension fund deficit of £1.84bn represents a long-term liability that also could be seen as a form of debt.
Tesco has a lot of on- and off-balance-sheet debt, but its strong profits and working capital position allow it to service this comfortably. The relatively stable profits from food retail, along with its industry position, allow Tesco to operate with this level of debt. Weaker firms in less stable industries may find similar financing structures less comfortable.