Dealing with Debt

10th Sep '19 by Gromley

7 comments 1755 reads

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,…

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TB_Investor

11th Sep '19

Some fantastic points here Gromley,

I had a quick look for any Half Year/Full Year RNS's that used IFRS16, saw SIG (LON:SHI) had reported using this new accounting method. Interesting to see that once this update came through net debt jumped from £188m in 2018 to £452m - Its stock rank then dropped dramatically as all measures you mention above are re-calculated. This will no doubt put a lot of the screens and calculations out of kilter. Like you I'm not sure what the answer is here.

Thanks for adding your thoughts on this enjoyed the read!

Gromley

12th Sep '19

Thanks tb,

interesting to look at another example in the form of SIG (LON:SHI) .

The StockRank has collapsed since the publication of their results from :

86 (1st Sept) [Q79 V71 M62]

to 45 now [Q38 V70 M38]

In fairness the underlying results were probably sufficient to account for a lot of this fall, but the re-categorisation of debt cannot have helped.

As you say reported debt jumped massively (when in fact the underlying was healthily down).

Enterprise Value (a small part of the VR calculation) is also sharply up. £1,190m on today's numbers but would have been £900m under the old methodology. (30% increase).

On another note, I see that WM Morrison Supermarkets (LON:MRW) announced their interims this morning. They took the decision to restate the prior year for IFRS16 as well as the current; a sensible move I think in that it gives us a better comparative. However, their net debt will now show as £2,358m as opposed to £975m(reduced by £22m over the half year).

This caused one poster on another site to comment "They should not be paying a special dividend when they have a Net debt GBP2,358m" . I won't comment on whether they should or should not pay a special dividend, but it is interesting to see that people are already making interesting analysis on the new basis of numbers.

As if this investing lark wasn't hard enough at times already!

Vsihv

Great article - thanks Gromley - did not even consider the impact on stock ranks as a result.

Some rambles for me - haven't gathered my thoughts so verbal diarrhoea that is likely to confuse further!

Re the accounting treatment, have not actually read the standard, but effectively this is asking to treat operating leases the same way as finance leases and finance lease liabilities I would expect to see (certainly treat as) debt.

Its not really a construct I agree with, given the definition of assets and liabilities:
Asset: Something arising as a result of contract or transaction, from which and inflow of future economic benefits is expected
Liability: Something arising as a result of contract or transaction, from which and outflow of future economic benefits is expected

Under this, I can see the liability, but not the asset - the asset only exists if you continue to make good on the liability, but of course, then you would have large liabilities without the corresponding asset, which would be equally ridiculous and result in a mis-match balance sheet unless you start doing something with the reserves.
From a reporting perspective, EBITDA should be higher than Operating Profit, which in turn is higher than net profit, so multiples might not show the change.
Of course, that is still complete nonsense - assuming a finite life of a business with growth = inflation and constant margins and the finite life same as the length of leases, you will find EV coming down rapidly, while EBIT and earnings are going up rapidly relative to EBITDA.

Personally, I would say anything contractual and committed should be treated as debt, certainly material pension outflows, but I have more sympathy with operating leases not being added, because as we have come to realise, these do get restructured (and often before debt / pension obligations), and are unsecured in the event of bankruptcy.

The Phoenix

Hi Gromley,

If my memory serves me correctly I think you flagged this for me the other week re Macfarlane am I right in thinking that the Stocko debt figure quoted was correct in the end as it included lease liabilities.

Forgive my haziness been working twelve hours days last couple of weeks and with middle age entraced the old fizz-ogg isnt what it used to be.

Thanks

Andy

To be fair Andy, you actually flagged it to me - I hadn't realised the full implications of IFRS16 until you raised the question re Macfarlane (LON:MACF)

My last thoughts on that thread were : "Pretty sure it would be wrong though to describe either as 'debt'."

Which turned out to be, erm well WRONG. Technically at least, I'm still puzzling over how we should best consider these liabilities. To (mis)quote Bones McCoy "It's debt Jim, but not as we know it"

Mike888

29th Sep '19

Good, really useful article Gromley,

For me I think it's a good thing, yes it screws up screens and it will also take a swipe at stockranks until we get used to the new norm. But at least we have the transparency on the balance sheet, then we can choose to decide whether it's impactful to our investment thesis or not. I'd have thought most investors would look at the balance sheet prior to buying anyway, so maybe not such an inconvenience,

But obviously, and as you say, screening criteria would need to be changed, and the downside of that would be that some dross now creeps into the screen. But having said all that, I'm now not quite sure what I would consider a safe debt ratio for me to screen against. Hmmm, one to ponder

xcity

I think that most of these adjustments are misconceived and will simply encourage jiggery-pokery.

Information is important but these standards don't really offer that.
Short-term debt and long-term debt. Ideally we'd have full details of when (and in what circumstances) debt becomes due.
And ditto for leases if we are going to look at them. At the moment we tend to look at leases as undesirable commitments (not sure about debts). But the desirability actually depends on the rental levels and terms and the type of property involved. Some are actually assets.
Capitalising development costs appears to be acceptable. Even if it is an annual requirement. Even if what has been developed doesn't have a verified commercial value (yet).

I see many comparing PERs across decades. But 50 years ago accounting treatments tended to be much more conservative. Property tended to be freehold and recorded at historic cost. Pension funds were more likely to be assets than onerous commitments. And all quoted PERs were historic not prospective.

Personally I prefer just to follow the money. Despite Patisserie Holdings (LON:CAKE) it is harder to fiddle cash and cashflow. Everything else is just probability and prediction.

Dealing with Debt

Changes to the definition of debt.

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Gromley

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