The Investment Checklist
Page 15
Inflation Risks
There are various types of inflationary risks—such as increasing costs (including wage inflation) and rising interest rates—and you need to develop an understanding of how each of these inflation risks will affect each of your investment holdings. This will prepare you to make investment decisions in an inflationary environment. Let’s take a closer look at each of these risks.
Wage Inflation
Businesses with a large number of employees, such as a grocery store, will be affected by wage inflation. Wage inflation can come from a variety of sources, such as an increase in the minimum-wage rate in a particular state, increases in the costs of benefit packages, or high employee-retention rates. Whatever the source, rising labor costs significantly reduce free-cash flow.
Rising Interest Rates
Most stocks are negatively affected by rising interest rates. In a rising interest-rate environment, the price-to-earnings ratios of stocks typically drop. This is why stocks have always tended to perform badly during periods when inflation is rising and corporate earnings are declining. Businesses that invest in real estate would be negatively affected, as capitalization rates in a rising interest rate scenario increase which would then decrease overall asset values. If a business has large amounts of variable debt (versus fixed-rate debt), then rising interest rates will also increase interest expense.
To evaluate the effects of inflation on potential or current holdings, determine how well the business will be able to maintain cash flows in real terms in scenarios where material costs, wages, or interest rates are rising.
25. Is the business’s balance sheet strong or weak?
A strong or weak balance sheet may be the difference between your investment facing insolvency or simply a bump in the road. A strong balance sheet will provide management with the financial flexibility it needs to take advantage of opportunities during all economic periods. Your primary goal should be to figure out if the cash-flow stream the business generates is predictable enough to assure that debt payments, both on and off the balance sheet, can be made. You need a sufficient margin of safety to pay the debt over time should cash flows decline.
Let’s start by looking at a business’s motivation for taking on debt.
Identifying a Business’s Motivation for Debt
It is often useful to determine the motivation behind a business’s debt on the balance sheet. Did it take on debt to fund losses, make acquisitions, pay special dividends, or enter new product lines?
For example, during the credit boom in 2005 to 2007, many businesses were taken private by private-equity firms and subsequently taken public again. In order to recover more of their equity investments in these businesses they had just taken public, the private-equity firms forced the businesses to issue debt and pay large one-time dividends. Dominos Pizza, for example, issued a special one-time $13.50-per-share dividend to shareholders. CEO David Brandon could provide little justification for this action, stating only, “We believe this new capital structure is the appropriate corporate finance decision for our company.” This and similar scenarios saddle many businesses with high amounts of debt. Management often attempts to justify its actions by stating that the balance sheet needs a better capital structure and needs leverage to maximize the value of the business. When you discover a business in this situation, realize that you are considering partnering with a management team and board that may have compromised the financial strength of the company.6
Considering the Advantages of Low Debt
There are several advantages to businesses with limited amounts of debt. Think of limited debt as, say, debt that can be paid back in less than three years out of existing cash flows. First, the business has less risk of entering bankruptcy, allowing you, as an investor, to sleep better at night. Second, a strong balance sheet allows the business to be opportunistic. Businesses that have strong balance sheets are often able to gain competitive ground, because they are able to invest in their business in ways that their leveraged competitors cannot. For example, during the credit downturn that began in 2008, those businesses that were beholden to the credit markets were scrambling for cash to pay off debt, while those in a stronger position were able to be opportunistic and buy back stock, make acquisitions, or grow.
Case Study of a Company that Uses Debt Conservatively: Brookfield Asset Management
Global asset manager Brookfield Asset Management is a great example of a firm that uses debt conservatively. Brookfield strives to finance its business on a conservative basis by financing its operations primarily using long-term, investment-grade, non-recourse debt. Most debt is secured by specific assets, which ensures that the weak performance of one asset or business unit will not hurt the rest of the company. To further protect itself, Brookfield will only borrow the amount that it would typically be able to pay back in one business cycle.
Brookfield also staggers the maturity of its debt repayments so that they don’t all come due at the same time, thus decreasing refinancing risk. Brookfield will typically finance assets that generate predictable long-term cash flows with long-term fixed-rate debt, instead of variable-rate debt, in order to provide stability in cash flows and protect returns in the event of changes in interest rates. It also maintains access to a broad range of financing markets, such as equity and debt markets, so that it can facilitate access to capital throughout the business cycle. This way, it is not dependent on any particular segment of the capital markets to finance its operations.7
Determining How Much a Business Can Borrow
You need to determine how much a business can borrow. The capacity to borrow depends on several factors, such as profitability, stability, relative size, asset composition, and the industry position of a business. It also depends on external factors, such as credit-market conditions and trends. During difficult credit environments, banks and other financial institutions are less likely to lend money and typically impose more restrictions, such as lower debt-to-income ratios. During easy-credit environments, financial institutions have looser requirements, such as higher debt-to-income ratios, as they try to expand the pool of credit applicants.
The amount of total debt a business can put on its balance sheet depends on the amount and distribution of cash flows a business generates as well as the value of the assets securing the debt. The more stable the cash flows are for a business, the more debt it can take on.
For example, think about a utility business, where the cash flows are steady. This business can easily handle high amounts of debt on its balance sheet. By comparison, a business with a more cyclical cash flow pattern, such as a homebuilder, cannot handle high amounts of debt. This is because it will have a more difficult time paying back its debt when its cash flows contract with the business cycle.
Factoring in Off-Balance Sheet Debt
To calculate the total debt of a business, you must factor in any off-balance sheet debt obligations. Any time there is a contractual obligation that does not show up on the balance sheet, you are dealing with off-balance sheet debt. These include:
Lease obligations
Warranties
Purchase contracts
Unfunded pension liabilities
Any other contractual obligations
These are typically disclosed in the footnotes to the financial statements under the section titled Commitment and Contingencies. Retailers, ship operators, airlines, and many other types of businesses have large contractual obligations that are off-balance sheet.
For example, many businesses rent buildings and equipment using long-term lease contracts. If these lease obligations are classified as operating leases rather than capital leases, they are not required to be reported on the balance sheet and are instead placed in the footnotes. However, these required rental payments are contractual obligations similar to debt. A good rule of thumb for estimating a business’s total lease obligation (and a method that is often used by credit-rating agencies) is to multiply one year’
s rental expense by seven. Otherwise, you will have to discount the future rental payments to the present using a discount rate.
Another example of an off-balance sheet liability is when a utility is required to purchase a certain amount of coal per year at a fixed price per ton, or when there is a lawsuit that is pending and the business has estimated potential liabilities in the form of damages it will be required to pay in the future.
Using Ratios to Determine a Company’s Ability to Pay Its Debts
There are two types of ratios you can use to find out how easily a company can pay its debts. One is coverage ratios, and the other is static ratios. Let’s look at each individually.
Coverage Ratios
Coverage ratios measure the ability of a business to meet fixed obligations. A coverage ratio takes the income available for paying the total fixed obligations for a given year and divides that by the annual interest expense and fixed charges. There are various types of coverage ratios:
Earnings before interest, taxes, depreciation and amortization (EBITDA) to interest expense
Earnings before interest and taxes (EBIT) to interest expense
Cash flow from operations to interest expense
For example, if a company generates $200 million in pre-tax income and pays $50 million in interest expense, then its interest coverage ratio is four times. This is the number of times a business can cover its interest expense out of pre-tax income. A more conservative calculation uses EBIT, which does not add back depreciation charges. Many times, depreciation charges equal the amount needed to maintain a business’s assets, which is a real cost to the business. By not adding back depreciation, you are effectively accounting for those maintenance costs.
When calculating coverage ratios, it is preferable to use cash flow for the numerator because liabilities must be paid in cash. Earnings are a softer accounting measure and can be manipulated, so using cash flow provides a more consistent, dependable measure.
To interpret coverage ratios, you must consider the distribution and predictability of cash flows. You cannot use one coverage ratio, such as five times EBITDA to interest expense, for all businesses, and assume it is conservative. The more cyclical the cash flows, the higher the coverage you will need. Healthcare and pharmaceutical companies typically have a more narrow distribution of cash flows than, say, oil and gas companies. For example, a conservative coverage ratio for a healthcare company might be EBITDA/interest expense of eight times, but it might be 10 times for an oil and gas business.8
Static Ratios
The next most useful ratios are static ratios, which measure the ability of a business to repay its debt obligations at one point in time. These include:
Current assets to current liabilities
Debt to equity
Debt to total assets
Using Rating Agencies
One simple and straightforward way to understand the degree of leverage on a business’s balance sheet is to examine the ratings from firms such as Moody’s, Standard & Poor’s (S&P), and Fitch. You should not rely on these ratings, but you should instead use them as a starting point. These are publicly available, and they will help you to gain a quick insight into a business’s balance sheet. Rating agencies focus on examining a debt-issuing company’s assets, financial resources, earning power, management, and the specific provisions of the debt security.
Below are sample coverage and static ratios that Moody’s uses to rate debt:
Table 5.1 EBITDA/Interest Expense Ratios
Company Rating EBITDA/Interest Expense Ranges
Aaa to A 17× to 8.2×
Baa to B 5.1× to 1.5×
Caa to C 0.3×
Table 5.2 Debt to EBITDA Ratios
Company Rating Debt to EBITDA Ratio
Aaa to A 0.9× to 1.7×
Baa to B 2.4× to 5×
Caa to C 6.3×
J. Tennant, “Moody’s Financial Metrics Key Ratios by Rating and Industry for Global Non-Financial Corporations,” Moody’s Special Comment, December 2007.
The downside to using these ratios is that they only give you a snapshot of the business at a certain point in time. A business can change dramatically from quarter to quarter, so static ratios can be misleading when not analyzed over a longer time frame. For example, if you are analyzing a retailer, the ratios will fluctuate depending on the quarter. In the first and second quarters, the retailer is stocking up on inventory and may have greater debt, more assets, and generate less earnings. In the fourth quarter, the same retailer may have less debt and assets but generate higher earnings because of holiday sales.
Assessing the Short-Term Financial Strength of a Business
You want to get an understanding of how liquid the balance sheet is, which tells you the amount of time the business would normally require to convert assets into cash. This will help you assess the ability of a business to pay its short-term liabilities. Short-term liquidity is extremely important to lenders because it is the inability to pay short-term liabilities that causes most businesses to enter bankruptcy.
The assets on a balance sheet are organized in order of their liquidity. The current assets are things such as cash, accounts receivable, and inventories. Long-term assets include property, plant, and equipment.
To determine a business’s short-term liquidity needs, evaluate how quickly the current assets on the balance sheet can be liquidated. First, start with cash.
Cash
Sometimes cash is not as liquid as you may think, so you will need to make adjustments. Many businesses earn their revenues in foreign jurisdictions and keep cash balances in the country where they earned the revenues, in order to avoid paying taxes in the United States. If such a business were to repatriate this cash to invest in the United States, then you would need to discount the cash for the taxes the business would have to pay. For example, in 2009, computer manufacturer Dell had the majority of its cash domiciled in foreign jurisdictions. If Dell wanted to use this cash to buy back its stock in the United States, it would have had to pay taxes in the United States at rates as high as 30 percent. Therefore, the cash balance needs to be adjusted for these potential taxes.
You may also need to make adjustments to the cash balance for the amount needed to fund operations. For example, children’s retailer Build-A-Bear Workshop had $60 million of cash on its balance sheet as of the fourth quarter of 2009. However, by the end of the second quarter of 2010, Build-A-Bear’s cash balance had declined to $31 million. This was due to Build-A-Bear’s need to build inventory during this period in advance of the busier holiday season. An investor who assumed that $60 million in cash was available to pay short-term obligations would have been making a mistake, due to the fact that Build-A-Bear’s cash balance fluctuates due to seasonal working-capital needs. Investors should normalize cash amounts to account for these patterns.
Accounts Receivable
Next, you need to understand the quality and liquidity of a company’s accounts receivable. This is especially important for those businesses that sell on credit. You need to calculate receivables turnover in order to understand how quickly a business is able to collect on its accounts receivable. This is the time needed to translate receivables into cash. The receivables turnover is calculated by dividing net sales by average total accounts receivable. You can convert this to the number of days it takes to turn accounts receivable into cash by dividing the turnover figure by 365. For example, if it takes 120 days for a business to convert its receivables into cash, and it had only 30 days to pay down short-term debts, then a business might potentially face a short-term liquidity crunch. In other words, the bills are coming in before the money is there to pay them!
Inventory
Understanding how long it takes to convert inventory to cash will also help you understand how quickly a business can pay back its short-term liabilities. You can calculate this by dividing the cost of goods sold by average inventory. Convert this to the number of days it takes to turn inve
ntory into cash by dividing this turnover figure by 365.
Inventory is an important asset and inventory turnover represents one of the main ways that a business generates revenue. A business needs to have sufficient inventory because if it runs out of products it will lose sales. Having too much inventory for long periods, however, is not good either. In addition to failing to produce revenue, a business would have to pay to store it, and it can go bad or become obsolete.
Assessing the Long-Term Liquidity Needs of a Business
Short-term liquidity is far easier to evaluate compared to long-term liquidity because it is easier to make a reasonable projection in the short run than the long run. If you are unable to make long-term projections (which is often the case with cyclical businesses), then you will more than likely be unable to understand the long-term financial strength of a business. As a result, the measures used to evaluate the long-term liquidity needs of a business are less specific. The liquidity will depend on whether the business has permanent equity capital or uses short-term funds, which are temporary and thus a more risky source of capital.
One business that uses permanent equity capital instead of short-term funds to finance its business is global asset manager Brookfield Asset Management. In 2010, Brookfield was funded by $30 billion of permanent equity capital. CEO Bruce Flatt explained why, “This is capital that does not come due, has no margin calls and whether it trades for less in the market due to external factors has very little effect on the capital base.”9 Over the years, Brookfield has been strengthening its permanent equity capital in order to strengthen its balance sheet. For example, in 2001 when Brookfield converted debentures, which are mid- to long-term debt, into common shares, this added permanent equity to Brookfield’s capital base. It also strengthened the balance sheet and eliminated the interest cost and risk of these debentures.