Companies use leverage because it can boost earnings, and that's a good thing. But leverage is also bad because it increases the volatility of earnings and increases the risk of bad things happening such as rights issues, dividend cuts and bankruptcy.
The trick is to find companies with the “right" amount of leverage given your investment goals, and that requires the right tools for measuring leverage.
Measuring leverage in non-financial companies
Leverage in non-financial companies is definitely easier to get to grips with than it is for financial companies like banks and insurance companies.
For the sort of relatively defensive companies I'm looking for, those with consistent records of profitable dividend growth, it basically comes down to borrowed money. How much has the company borrowed and how does that compare to its ability to pay the interest on those borrowings in both good times and bad.
There are lots of different ways to approach this. Two of the most popular are:
- Interest cover, typically defined as operating profit divided by interest
- Net debt to EBITDA, where net debt is total borrowings net of cash and EBITDA is earnings before interest, tax, depreciation and amortisation
Personally I don't use either of these because they rely on last year's earnings, which may not be a good guide to a company's typical earnings over a number of years.
Given that debts are likely to be carried for many years into the future I think it makes more sense to compare debt or interest to a company's average earnings over a number of years, in other words to its general “earnings power". The result should be a ratio which is more reliable and robust than those which depend on a single year's earnings.
So my rule of thumb for conservative leverage in non-financial companies, taking an average earnings approach, is:
Don't invest in a company if its total borrowings are more than 5-times its earnings power (defined as 5-year average adjusted profit after tax)
From experience a ratio of 5 seems to be a reasonable figure which most companies can meet, but beyond which debt related problems begin to be more common.
I use profit after tax in the ratio rather than EBIT or EBITDA because it has interest removed, which will increase the ratio (and decrease the allowable debt) for companies that have to pay a higher interest rate on borrowed money.
And that's all I look at for non-financial company leverage.…
