Investing Knowledge |
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
On debt and equity By Peter Temple
Most analysts use the term gearing pretty freely, but it's worthwhile exploring exactly what it means, and what implications it has for the value of a share. The simplest definition of gearing, sometimes called the debt-equity ratio, The borrowings part of the fraction includes both short-term and long-term items. Typically it takes into account bank borrowings and overdrafts, the current portion of long-term debt, medium and long-term bank borrowings, and currently outstanding bond issues. It's normal to deduct cash and short-term investments from this number to arrive at net borrowings. Shareholders' equity goes by a number of different names, including book value, stockholders or shareholders funds, net assets, and net tangible assets. Normally, what's meant by this is tangible fixed assets plus current assets, less current liabilities, long-term creditors and provisions. The end result of this calculation is the residual assets that are 'owned' by shareholders. Intangible assets But is the figure for tangible assets the right one to use? Accounting conventions now allow companies to use intangible assets more explicitly as part of their balance sheet. To some extent they could always be incorporated. But the difference now is that analysts tend to take a more lenient view about them. Twenty years ago, when I worked in the City, there was considerable scepticism about the real value of intangible assets. It's a scepticism I still feel personally. But times change. The advent of asset-light 'people businesses' has been influential. It means that more companies have intangible assets on their balance sheets. The trick is to recognise when these assets make a genuine contribution to the business. It's not always obvious. That's why the conservative way to calculate gearing excludes intangible assets from the denominator of the gearing fraction. One footnote here is that many cash-rich companies have negative gearing. In other words, their cash exceeds their borrowings. Gearing - good or bad? Gearing provokes more debate than almost any other financial ratio. Like many other financial ratios, it is the context that is important. Is the gearing ratio significantly higher than the company's major competitors? Is the underlying business stable? Does the company generate reliable flows of cash? Are the valuations of the company's assets up to date? Are interest rates moving up or down, and how much of debt is variable rate? There are no hard and fast rules. High gearing could mean that the company is dangerously overextended. Or it could simply be that the company's assets are undervalued and therefore that the true shareholders' equity number is higher than the balance sheet might indicate, and gearing overstated. Another interesting context is that companies with stable reliable cash flow can support higher levels of gearing than those in more volatile businesses. Many bankers, for example, lend against historic and projected future cash flow and do so against a backdrop of conventional gearing levels within a company that might make many quoted company analysts' eyes water. Gearing need not be bad. If profits are rising, high gearing can enhance profit growth and returns to equity shareholders. Other things being equal, the profits of highly geared companies can benefit if interest rates are falling, and if the debt is paying interest at variable rates. Equally assets can be overvalued and gearing therefore understated, high gearing will exaggerate falling profits, and highly geared companies may suffer if interest rates rise. Peter says Financial theory - for the technically minded, it's called the Modigliani-Miller theorem - suggests that investors should be indifferent to a company's capital structure, provided that the company is minimising its cost of capital. In other words, there should be no distinction drawn between a company that has high levels of debt and one that has no debt. It's the theory that launched a thousand share buybacks. However, in the real world, things are different. Gearing does, if nothing else, affect investor sentiment. When times are tough, highly geared companies are seen as vulnerable. They may see their stockmarket rating and credit ratings suffer, and find it harder and more costly to borrow. I am, for example, one of a generation of analysts and investors that saw highly geared companies go bust by the score in the mid-1970s bear market, and many more suffer several subsequent years of being shunned by investors until they repaired their balance sheets. So it doesn't pay to minimise the importance of gearing.
|
|||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Send Article by Email