A lighted match on a petrol station forecourt could prove a lethal combination. For investors, trusting their cash to a company that is highly operationally and financially geared is an equally toxic mix.
There are many checks investors can carry out when assessing the financial position of a company, but measuring its gearing should be at the top of the list. Gearing comes in two forms:
• Operational – a slight drop in revenues could lead to a huge decline in profits due to a firm’s high and mainly fixed costs
• Financial – companies need to keep servicing interest on their debts, irrespective of the trading conditions
If either of these is too high investors’ cash could be at risk. If both are present disaster could not be far away if the company operates in a cyclical industry.
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The reality of high operational gearing for a cyclical business during a downturn would test the resolve of even the most experienced of investors. However, there is an upside. When the economy picks up a minor rise in sales could generate a huge boost in profits.
Generally, highly operationally geared firms are riskier businesses and therefore need to generate a higher return on investment to compensate for the dangers entailed. Car makers or housebuilders as well as airlines and engineering concerns are by their nature highly operationally geared and all are exposed to cyclical end markets. When looking to invest in these sectors you can limit the risks by focusing on firms with a strong competitive position, where, for instance quality brands or high barriers to entry, bestow a degree of pricing power. A look at the split between a company’s variable and fixed costs will give an indication of how vulnerable are its profits, and ultimately the cashflows are used to strengthen competitive position and fund dividends.
Variable costs include raw materials and change in line with the volume of goods or services shipped. Fixed costs, however, such as rent, utility bills and the depreciation charges relating to plant and equipment have to be paid regardless of how the company is performing. A relatively static ‘cost of goods’ line in the profit and loss account, despite volatile sales, is a red flag in this regard.
Mine tunnelling specialist Shaft Sinkers’ (SHFT) 2012 profits crunch illustrates what can happen when sales take a dip at a highly operationally geared business. As the above table illustrates, high fixed costs can greatly amplify a relatively modest reduction in revenues, in this instance a 15% retreat in sales translated into a 75% drop in pre-tax profits.
You will see here how cost of goods fell 10% in 2012, only two thirds the 15% rate of decline in revenues, while operating expenses slid 25% all of which suggests the firm has a relatively fixed cost base. A quick check to gauge the fixed-asset intensity is the line ‘property plant and equipment’ in the balance sheet. Compare this to shareholders funds and sales. Capital-intensive industries that use a lot of kit will have a higher ratio than software or service firms where the assets are people, not manufacturing equipment.
Financial gearing (net debt ÷ shareholders funds) × 100
Interest payments on debt are essentially a fixed cost too. Irrespective of whether sales are buoyant or experiencing a cyclical lull, financially geared businesses will have to keep honouring their debt financing charges.
To establish how financially geared a company is take its net debt, which is its total debt minus its cash, and divide it by shareholders funds. Expressed as a percentage, this ratio tells you the significance of a company’s borrowings to its capital structure, how much of its funding comes from debt versus equity.
There is no correct level of this gearing, but 50% or more is considered high. Financial gearing, however, needs to be seen in the context of the industry in which a company operates, if a firm operates in a cyclical industry then it won’t be able to tolerate such a high level of indebtedness than another operating in a stable industry with a clear view of its future earnings.
A highly geared cyclical business will typically attract a lower valuation to reflect the risks, which in turn will be reflected in a high beta, with the counter’s historic volatility likely to have been in excess of the market. As we know from Checklist 8, beta is a key component when establishing a company’s weight-adjusted cost of capital, by directly affecting its cost of equity. Companies with higher betas, and therefore higher costs of equity, will need to produce a greater return on invested capital to demonstrate they can create shareholder value.
However, for a secure business generating high-quality earnings, funding it with debt will not necessarily increase risk. A regulated utility business, for instance, where inflation-adjusted prices are visible many years into the future, may never have an issue servicing debt which is cheaper than equity.
It is no good loading huge debts on a cyclical company which is highly operationally and financially geared. Running into the 2008/09 financial crash and ensuing recession both British Sky Broadcasting (BSY) and ITV (ITV) were carrying large amounts of debt, but the former managed to keep paying dividends throughout the period, while the latter cut its in 2008 and passed the payment altogether in 2009 when avoiding a breach of bank covenants was more important than maintaining shareholders payouts. ITV’s high operational gearing stems from the fixed cost of running terrestrial transmitters, so chief executive officer Adam Crozier has been wise to focus on paying down debt since 2010 with the firm now enjoying a net cash balance sheet.
This is an edited version of an article first published by Shares in November 2013.