Paying the ferryman - The impact of rising rates on businesses

This is an article to be published in the Australian Financial Review next Monday on line, and in print this Wednesday. We have chosen to make it available to members beforehand ,with some slight alterations. The date of publishing means the stocks referred to are relevant to that time. As always, use Stockopedia to understand how the debt position of your businesses are structured.

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Companies are often required to tap the global markets to source debt funding and Central Banks across the developed world have sought to reign in inflationary pressures with rate rises that have impacted debt markets. So now that rates have reverted to more normal levels post the pandemic all time lows, the net outcome of higher rates is that it will cost more for our companies to raise debt financing into the future. Subsequently this could potentially have a very big impact on margins for those who are heavily indebted and are unable to pass those costs onto customers.

So this reporting season, look for those companies with higher debt ratios to put a continued focus on reducing debt this period to help alleviate future pressure. This is something many had done at the time of their interim reports six months ago. Which leads to the question, “How do we measure a company’s debt exposure and whether it is ‘excessive?’”

The market traditionally looks to Debt-to-Equity as a measure of a company’s indebtedness, how much of a company's assets are funded by debt, and how much by equity. A company which is too heavily leveraged on debt to fund a businesses asset base is more susceptible to problems should rates rise. This often quoted ratio is available through most platforms with other valid variations including “Net Debt to Equity” (Stockopedia refers to it as Net Gearing) which considers debt on the books net of cash and “Net Debt to Tangible Equity” which uses the book value of equity excluding goodwill and other intangibles. The exclusion of intangibles can also be applied to the traditional D/E calculation.

However investors seeking to find more detail by considering other ratios such as:

• Long term debt to Equity - Long-term debt is debt due for repayment in over 12 months and is not included in the current liabilities figure on the balance sheet. It includes debts that most likely will be interest bearing such as syndicated debt facilities, mortgages and long-term leases, but not general trading liabilities.

• Free cash flow to long term debt - This ratio attempts to capture how easy it is for a firm to service its current long term debt obligations from its current cash flow including what it needs to support operations and maintain its capital assets. Higher the better, however this ratio can be subject to higher volatility than others as it relies on cash flow which can be more volatile than values on a balance sheet.

• Altman Z score - Developed in 1968 by Edward I. Altman, an Assistant Professor of Finance at New York University, the Altman Z-score is a combination of five weighted business ratios that is used to estimate the likelihood of financial distress. It attempts to identify how closely a firm resembles other firms that have filed for bankruptcy, and by extension how close to failure it is. It's quite a complex calculation and the company won’t calculate it, so you need to source it in Stockopedia.

Below is a list of companies (Yet to report this earnings season), who may look to reduce their debt balances in order to avoid future pain in this “new interest rate normal world”. Sorted alphabetically

One important thing to note. These measures are not a sole reflection of possible future problems. For example, most listed companies (especially small ones) have no debt on their balance sheet however, they are no less risky. Therefore be careful when simply looking for stocks with low debt levels. After all - what bank in their right mind would lend money to a company who is not profitable and not generating any cash? So be sure to look at a company’s debt in context as a low (or high) figure may not necessarily equate to ‘safe’ (or ‘unsafe’). Ideally compare a company’s levels against their long term history, and also against that of their peers and current operations.

A cheat for Stockopedia members

Now that I have gone over the hard way, let’s talk about the easy way as Stockopedia is built around saving you time, especially at this busy time of year. As discussed above, rarely should debt figures be looked at in isolation and are often more powerful when combined with others. In Stockopedia the closest thing to an overall measure is the Quality Rank. Essentially if your company has a good quality rank it increases the chances of them absorbing higher interest rates without resulting in too much disruption of the business.

The Quality Rank looks at Bankruptcy & Earnings Risk which is one important in overall calculation of the score. Measures included are:

• Altman Z-Score, a bankruptcy meter (as discussed above)

• Beneish M-Score, an earning manipulation flag (discussed in depth here)

• Current Leverage (Net debt to assets as discussed above)

These are then combined with other quality measures like the Piotroski F-Score, return on capital employed, margins, cashflow and sales growth. If you want to learn more about the Quality Rank and why it is so important is helping assess a company’s ability to absorb debt then read here. But one thing is clear, the Quality Rank is an important measure to watch during reporting season.

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