The recent travails of companies such as Carillion (LON:CLLN) and the AA (LON:AA.) have underlined the dangers of high levels of debt on corporate balance sheets.
The combination of zero interest rates and bond buying by central banks across the developed world has encouraged a certain number of companies to run up high levels of debt, which they then struggle to pay down or even service from cash flows.
While this may be most obvious in the US, where aggregate corporate net debt/EBITDA ratios have risen inexorably since the 2008 Financial Crisis to extremely elevated levels today (1.5x today according to Bloomberg, versus just 0.8x pre-crisis in 2007), this is also an issue with certain UK and European companies too.
A very high level of debt, combined with underlying problems with the business model was Carillion’s undoing. In the AA’s case, net debt level of £2.5 billion currently sits at 5 times the total value of the AA’s equity, and nearly 20 times the value of AA’s estimated net profit for this year (£127m).
As the Bank of England raises the UK base rate further, and long-term interest rates creep back up in line with the trend in US Treasury bonds, companies with such high debt loads could find themselves increasingly struggling to refinance these debts.
Debt plus structural decline: a dangerous mix
There are a number of sectors with structurally challenged business models: Retail is an obvious case in point, with high street shops threatened by changing consumer tastes and online retailers like Amazon. This has resulted in a number of bankruptcies at the likes of Toys R Us, BHS and Comet in the recent past.
Building contractor and engineering companies like Carillion (LON:CLLN) are clearly another, typically bidding for huge contracts which can at best, only generate very low profit margins for the company but which can result in substantial losses in the case of cost or time overruns.
Casual dining is a third sector under huge pressure from pressures on consumer spending and over-expansion, with a number of non-quoted restaurant chains running into difficulties and closing down including Byrons and Jamie’s Italian.
Focusing on profit margins and cash flows
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