1 (more) thing every investor needs to know about debt

I wrote an article earlier today about the importance of examining the size of a company’s debt. The other side of the debt coin is a company’s ability to repay. Some businesses, like Telstra Corporation Ltd (ASX: TLS), can run up large debts because their ability to repay those debts is very strong.

Here’s two quick ways to look at a company’s ability to repay its debt:

Interest cover ratio

A common way to measure a company’s ability to cover its finance costs is through the ‘interest cover’ ratio, which is generally Earnings Before Interest (EBIT) divided by interest payments. Most companies report EBIT and finance costs so you can just hit ctrl + F and search for these in the latest annual report.

In keeping with the previous article, I’ll use Woolworths Limited (ASX: WOW) as my example. In the most recent half year, Woolworths reported EBIT of $1,301 million. It paid $113.5 million in finance costs, giving it an interest cover of 11.46 times, which is quite decent.

However, Woolworths does not report the interest cover ratio. Since it also has hybrid notes to account for, it uses something called the ‘service cover ratio’ which is EBIT divided by net financing costs and hybrid notes interest. It’s basically the same thing, and its service cover ratio is 10.13 times.

Fixed charges ratio

Another effective ratio is ‘fixed charges cover’, which reflects how many times over a company could pay its rent and finance costs from its Earnings Before Interest, Tax, Depreciation, and Amortisation (EBITDA).

Woolworths uses EBITDAR (R for ‘Rent’) and has a fixed charges cover of 2.4x. This means that the company could pay the equivalent of 2.4x its current rent and interest payments every year, giving it a margin of safety in hard times.

There are other metrics that are useful, including some that revolve around cash flow. These can be useful if some of a company’s earnings come from non-cash items, such as the revaluation of property. In that situation, a property company can report attractive earnings from property price increases that can make its ability to repay debt – as measured by fixed charges/interest cover ratio – look better than it is. Often management in these companies will specifically exclude these types of benefits or expenses from the ratios, but be sure to check.

The bottom line

Most companies report one variation or another of their ability to repay debt. Sometimes they prefer to focus on reporting the size of the debt (e.g. ‘gearing’) and other times they’ll use a coverage ratio like the ones above.

There are many things that can affect debt ratios, such as one-off expenses or non-cash adjustments (like property revaluation) which management may or may not account for in their calculations.  It is never wrong to calculate these metrics for yourself. At least if your answer doesn’t jibe with what the company is reporting, you’ll know to seek further explanation or a second opinion before making an investment decision.

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