Leverage, or debt as it is more commonly known, is a term that refers to money that a company has borrowed. When a company wants to invest in new assets, it needs cash to pay for them. That cash can come from one of three sources – sales and investment returns, equity capital or debt capital. Unlike equity investments, which give away a part of the company in return for cash, debt capital is money that is to be returned at a future date with interest.
Once raised, debt can be invested in new people and production capacity, to develop new products and bring them to market. It can be used to develop processes and procedures to improve efficiency, replace aging facilities and generally improve the business. If a company is short on cash to do these things, a fresh capital raise can generate strong improvements in the balance sheet and magnify performance. As an investor, these are all things I would consider to be a positive.
Drawbacks of leverage
When a company borrows lots of money relative to its income, it is considered ‘highly leveraged’. As any money borrowed has to be paid back at a future date, the company must be reasonably certain of generating a positive return with the capital otherwise it can suffer face severely detrimental effects.
For example, if a company generates £10,000,000 a year in revenue, but has borrowed £100,000,000 in capital, it would take 10 years to repay all that money if that was its only cost (which it wouldn’t be of course).
After cost of sales, taxes, capital expenditure, it might only have a third of that money left, meaning it would take the company a whopping 33 years to repay the money (again, if it diverted all the remaining funds to debt repayment, which it presumably wouldn’t).
Let’s say that it spend a third of its free cash flow on debt repayment – just £1,000,000 a year. That would mean it would take 100 years to repay the debt and that’s BEFORE interest costs. Does that sound sustainable?
Of course, there are mitigating factors. The company could increase its revenue, profit margins and cash profits over time, reducing the level of debt relative to income, its level of debt repayments as a percentage of profits, as well as the time required to repay the capital. The capital itself would likely have been raised for the very purpose of growing the company and in truth, anyone lending £100m to a company with an annual revenue of £10m must be either an idiot or fairly certain of that company growing over time.
What do I consider to be a ‘high’ leverage ratio?
Too much leverage can be crippling for companies, but how much is ‘too much’? As with the other items on a balance sheet, it comes down to a little bit of experience, some common sense and a bit of guesswork to create a rough estimate. If my earlier example was, Amazon back in the 1990s, then that £100,000,000 in debt would have been absolutely eclipsed by the company’s revenue growth and could have handled it without any trouble. If it were a fish and chip shop on the other hand…not so much.
Generally speaking, the more volatile a company’s earnings are, the less debt I am comfortable with it holding. That isn’t to say that stable or growing companies should leverage up to their heart’s content though, as even the most stable companies can hit choppy waters. I try to look at debt as a percentage of profits – anything more than four or five times the average profits of the last five or more years is generally too leveraged for me.
Having said this, this clearly won’t work for financial institutions like banks, who borrow all of their capital and lend it on. These organisations can instead by measured by their Core Tier 1 ratio, which is basically a measure of its most stable, valuable assets that can easily be converted into cash. The higher this ratio, the more secure the bank (I’m massively simplifying here, but the subject really requires its own article).
Every company requires capital with which to operate and a shortage of capital can be a noose around the neck of an enterprise. Taking on outside capital is often a sign of confidence in a company, but the level and terms of that capital should never be ignored. A capital raise magnifies that company’s ability to invest and grow, but it also comes with an implied restriction on future cashflow. If the capital grows revenue by, say 10% per annum, but the cost of repayment that debt is 11% of revenue, the company is actually reducing its strength by incurring another cost on the business.
If the lenders demand a quicker return of their capital, the costs can destroy the business as more and more money is poured into debt repayment and away from generating new revenue. As a result of this, I steer clear of companies with high or increasing leverage ratios due to the fragility it builds into the business model.