Dealing with Debt

Former readers of the, now defunct,  Motley Fool (UK) bulletin boards will no doubt recall that there was a personal finance section on the boards going by the same title as this article. This piece has nothing to do with that subject whatsoever, but I thought it made a snappy title.

This piece is actually triggered by accounting changes coming about from the adoption of IFRS16.

Changes to the definition of debt.

Well done! Your eyes have obviously not glazed over and you carried on reading beyond the uninspiring sentence above.

Before I go on I should point out that I am not a qualified accountant and this is just my layman’s interpretation of the reporting standards – do not take it as gospel.

Also if you are only moderately interested in this subject, you might what to skip the next section and go straight down to the heading “radical stepchange”.

IFRS16 requires companies to show on the balance sheet the liability arising from inescapable lease commitments and to balance this off with rights of use assets reflecting the future value of using these leases (or to be a little more precise – the future cost, effectively recognised in advance, of using these leases.

At face value this is a sensible step. Anyone that has looked in any depth at “bricks and mortar” retailers will be aware that many face a significant challenge from the fact that they have committed to Long Term leases on their stores at rents that are well above the current going rate. They cannot easily shut or downsize these stores as they remain liable to pay the rent for the full term of the agreement whether they use them or not.

I have thought in the pas t that some investors fool themselves by implicitly assuming that a company’s Net Tangible Assets Value (NTAV) is somehow indicative of how much they as an investor would get back should the business cease to trade.

Not true! There are liabilities not on the balance sheet :

• Up until comparatively recently (net) pension deficits were not on the balance sheet .
• Now lease liabilities are also there (although one needs to discount the rights of use assets to get towards a ‘realisable’ asset value).
• Statutory redundancy costs and probably a whole host of other liabilities, including wind up costs are still not on the balance sheet.

I’m not sure of the direction of travel of the accounting standards, but if this is a move towards being able to derive the “fire sale” value of a business from the balance sheet, then there is still a lot to do.

Thus far, my understanding of IFRS16 is that it is a positive in terms of accounting transparency.

However,

Radical Step Change.

What I had not appreciated until a few days ago was that these lease liabilities taken on to the balance sheet will be recorded as DEBT. I will ramble on later as to whether this is logical or not, but there are some important consequences of this change to consider.

When looking at the detail of individual stocks one can of course choose how to consider these leases (Paul Scott for example in the SCVR has indicated that he is largely ignoring this newly reported ‘debt’).

However if you rely on factors or screens, you have no choice as IFRS16 results are produced the new rules will change the numbers.

The Piotroski F score (0-9) for example includes one test  “Is the company's long term debt reducing or stable?” . Because IFRS16 does not require a restatement of the prior year numbers, pretty much every company with lease liabilities will fail that test for a period of one year. 

F-Score is also a key component of the QualityRank so that also will be distorted.

The ValueRank will also be (permanently) impacted as creating new debt increases Enterprise Value which of course impacts the Earnings Yield component of the VR.

There are undoubtedly other impacts on guru screens and other ratios.

I cannot really gauge how significant these changes will be (it will differ significantly company by company).

In fact one could argue that these changes will be beneficial ( Debenhams (LON:DEB) for example would have looked a much more risky proposition with the lease liabilities showing up as debt – it is fair to say that the market priced in those risks, but the factors did not.)

But whether or not these changes are an improvement or not there is a risk that they invalidate some of the factors or guru screens.  (The data on which these approaches were proven is now not the data we will see and test in the screens and factors going forwards.)

So what to do about it?

I’m afraid I haven’t really got a clue so would welcome ideas in the comments below. (I may well drill down on the impacts for some companies where they are major, but I don’t think I will be able to generalise from those examples.

Are the new reporting standards sensible?

  I wrote recently on a thread about Macfarlane (LON:MACF) that I thought it was incorrect to describe these liabilities as debt.

I was wrong on a technical level as the accounting standards are clear that this should be regarded as debt. However at the conceptual level I am now less sure.

One argument in favour of the new definition would be to consider a company sitting on an unencumbered freehold property. If they want raise cash from it and increasing their capital efficiency. They have two options :

• Take out a mortgage. This would always have been considered debt.
• Do a Sale and Leaseback. Despite having largely the same impact, this would not (until now) have been considered company debt.

As an aside, I have never really liked sale and lease-back arrangements, so if this change makes them look less attractive to companies I would consider that a plus.

However, from the other point of view I would argue that companies have many different types of liabilities on the balance sheet. In essence they are obligations to pay out cash (or other goods and chattels) at some time in the future (I’m skipping over prepayments etc.) And yet we choose to categorise only some of them as debt (which is “bad”/”risky”) and the rest as just liabilities (which apparently are not bad or risky).

So how do we categorise debt vs 'other liabilities'?

Predominantly I think based on whether or not the liabilities incur interest. I have not scratched very far below the surface here, but I believe IFRS16 in some way imputes part or all of the rental charges associated with leases as interest. (Happy to be corrected) That is not entirely convincing imho, but does technically support the idea that these leases are ‘debt’.

However, I do not actually think it is the interest charges that (should) cause investors to be wary of debt. Surely it is the risk that the entire sum of the debt may become payable ‘on demand’?

I doubt that many commercial lease agreements include onerous terms allowing the lessor to demand instant payment of all future commitments on the lease. (Not an area of contracting that I am familiar with, so again I stand to be corrected).

However, if I extend that argument, I would imagine that most commercial ‘mortgages’ also don’t contain (easily triggerable) clauses requiring immediate repayment of the entire capital.

Another, related,  concern with ‘debt’ (as opposed to other liabilities) would be the ‘covenants’ , which specify certain financial ratios that the company must meet in order to avoid a claim for instant repayment.

Do leases (or mortgages) routine have “covenants”? I do not know but my suspicion would be “not as such”.

Pension Deficits (which are not regarded as debt) often will involve commitments being made by the company to the pension fund which limit commercial flexibility. ( Reach (LON:RCH) for example has to make additional payments to the pension fund if they declare dividends above a certain level and have to get permission from the Pension Fund if they want to make certain acquisitions or raise additional funds)

I will stop rambling now.

Where I have come to in my own mind from this is to conclude that :

• If doing a detailed analysis of company’s financial stability one should consider all liabilities (and think about whether there are still others not required to be on the balance sheet).
• However if relying on ratios, factors or screens I cannot now really convince myself that “debt” is a useful measure.

This also helps me to reconcile a puzzle that I had which is why the “Bankruptcy Risk” [Altman Z-score] does not (directly) include debt levels in the calculation.

Sorry if you were expecting a profound conclusion here as to how we should amend our investment approach in the light of these new reporting standards. As is often the case my musings may have increased how much I know somewhat, they have increased the amount I know that I don’t know by a greater degree.

I now need to lay down in a darkened room, but it would be great is anyone (with the patience to read this far) can offer any other insights into this subject.