Financial Leverage: The Good, the Bad and the Ugly

by ifund · November 13, 2018

All financial institutions live and die by liquidity. We are a financial institution.

The fact that many people don’t think about it is beyond me. It is the essence of what we do.

–Ken C. Griffin

For consumers, debt can help them move into a bigger home or buy a new car, something they would need a lot of time to save the necessary amount. For a lot of people, managing their finances are hard and they live paycheck to paycheck; having a relatively small payment every month would make large purchases more available for them. The same could be said about companies, they need money to be able to grow their revenue/market share or release a new product line. This growth creates jobs and boosts the economy. Borrowing money is, first, cheaper than financing with own’s equity, second, better than diluting shares with outside capital. Borrowing can be done but with one condition – debt needs to be managed well.

Because of the pressure from investors and the need to perform better than competitors, managers of publicly traded companies are prone to take on more debt in order to grow revenue and increase profit margins.

To evaluate a company’s obligations, raw numbers can be used but they don’t say very much. Instead, ratios are favoured by analysts because they make it easier to compare companies and industries.

A debt to equity ratio (D/E) takes short and long-term debt a company has and divides it by stockholder’s equity, a manageable D/E ratio is between 1 and 3. But debt is not free, there is interest that needs to be paid. Banks use the next ratio before lending money – interest coverage ratio, the bigger it is, the better, but it should not be less than two. This ratio looks at current earnings before interest and tax (EBIT) and divides it by interest payment for the loan to see if interest payments would not be a burden for a company. Another ratio used is the current ratio, it measures company’s ability to pay the short-term debt (accounts payable) with current assets (cash and cash equivalents, accounts receivable and inventory). A good range is from 1.5 to 3, lower than that and company could run into problems covering their short-term liabilities, too high and management is inefficient in using current assets, but this ratio’s average value varies over industries. All three ratios are base for soundness and longevity of a company. Liabilities are like a double-edged sword, they can boost earnings, but they can also amplify losses.

If we look at one of the largest and well diversified companies Johnson & Johnson’s annual report for 2017 [1] we can extract necessary numbers for calculations for these three ratios:

D/E = (30,537+30,675)/91,714 = 0.67

Interest coverage = (17,673-934+385)/934 = 18.9

Current ratio = (17,824+13,490+8,765)/30,537 = 1.3

From this we can conclude that Johnson & Johnson has healthy amounts of debt, they easily cover interest expenses and can cover current liabilities.

When we look at Radioshack’s results for 2013 [2]:

D/E = (613.0+584.6)/206.4 = 5.8

Interest coverage = (-344-52.3+2.2)/52 = -6.6

Current ratio = (179.8+211.9+802.3)/584.6 = 2.0

It is visible that there is a huge debt burden and a net loss, which results in them not being able to cover interest payments. But the current ratio seems in a normal range, that might be explained by a huge inventory of possibly unsold goods. No wonder why Radioshack has filed for bankruptcy several times by now.

In a downturn, revenues for a company might drop by a significant amount; S&P 500 sales growth in 2009 reached a trough of -16.6% [3] and was in the red for almost a year. On average companies listed on S&P 500 saw a drop in operating margin from 9 to 2.5% [4]; consumer discretionary (non-essential goods) manufacturers were hurt the most, while healthcare was not affected at all.

These events can jeopardise the liquidity even for market leaders. But when a company is operating with a loss that does not mean that it will go bankrupt. For example, Tesla has been losing money for several years now, vastly expanding their production and revenues, but they also have had several injections of capital to stay solvent. To see if losses will be a problem, the place to look at is cash and cash equivalents, these will keep a company afloat for a moment when the management is trying to restructure their debt burdens and cut costs (e.g. lay off people and close down locations). When a company is over-due on their payments and the money has ran out, they either need to sell their assets or hope to be bought out or the worst case scenario – file for bankruptcy.

But this behaviour of over leveraging is seen also in “betting” on companies in retail trading, sometimes with money they cannot afford to lose. As said before, profits and losses can be magnified by leverage, this is one of the beginner mistakes made by traders because they think they can beat the market.

If there was one thing you should take from this article, it would be this: everyone should learn money management, whether you are a student, retail trader or a manager of large corporation. It will greatly benefit you making better decisions while managing your own finances. I know, I know a grey Bentley Continental GT looks nice on the driveway, but is it really worth the stress of not being able to pay the monthly loan payment when the going gets tough?

Authors: Elvis Dredzels, Dmitrijs Sokolovs