Gauging the debt levels of some ASX-listed stocks is not as easy as it may seem. Whether a company generates more than it spends or relies on external funding, after factoring in its operations, investments and financing, can require a lot more homework than most investors are willing to make.
To make matters worse, most investors trade on momentum and seldom give much thought to fundamentals and this plays into the hands of ASX stocks during reporting season.
Understandably, listed companies want to present their market update to investors in the best possible light they can, and the wriggle room embedded within Australian accounting standards allows them to do just this.
As a result, investors often struggle to distinguish between investment-grade stocks and those in varying stages of distress.
However, when looked at in isolation, debt can also lead to false assumptions about companies.
Healthier balance sheets
Since the global financial crisis investors have less tolerance for stocks with big borrowings.
Ironically, while companies with low levels of debt to equity were once berated for operating lazy balance sheets, they’re now being praised for prudent fiscal management.
While investment-grade stocks like to contain net debt-to-equity - which compares a company's net debt to its shareholders' equity - well under 70%, highly leveraged stocks in the banking, financial and infrastructure/utility sectors usually have enough cash flow to still justify an investment-grade rating.
Masking the true picture
Due to some fancy balance sheet footwork, stocks are able to successfully mask more meaningful signals of distress on their income statements.
Montaka Global chief investment officer Andrew Macken advised Azzet that companies try to hide financial leverage by focusing investor attention on earnings before interest and tax (EBIT), and often stripping out charges deemed non-operating.
Equally common is the practice of moving line items within a company’s cash flow statement.
The net effect of moving interest expenses to financing cash flow is that cash flow from operations can appear decidedly better than it really is.
Then there’s the art of making a balance sheet look better through off-balance-sheet leverage of minority shareholdings in associate companies.
As a case in point, Ramsay Healthcare recently conceded that by moving its 52.8% shareholding in underperforming France-based subsidiary Ramsay Santé to a minority shareholding it would remove the need to consolidate the accounts, which would allow it to classify group earnings as associate income.
By only owning 49.9% of a business, which may carry a lot of debt - as does Ramsay Santé - companies are not obliged to include it on their balance sheet and a lot of leverage can be disguised within its consolidated reporting.
By entering operating leases that are paid as an annual expense to use property and equipment, a company’s balance sheet, adds Macken, also can also understate its true debt.
When to ask questions
If there’s a significant gulf between operating earnings and bottom-line earnings or net profit after tax (NPAT), Macken urges investors to find out what it is and why.
One of the biggest problems with taking on excessive debt when times are good, adds Macken, is that when times turn bad, management is forced to sell assets at depressed prices or issue new dilutive equity.
Highly indebted companies have been more impacted by higher interest rates and Macken suspects many of these companies would be wiped out.
Conversely, lower rates will cost companies less to raise debt financing, and this could benefit margins.
Covenant waiving provides artificial relief for highly indebted companies, Macken equates to a corporate lifeline.
It’s never a great sign when private credit throws money at distressed stocks to save them from breaching financial covenants as we’re currently witnessing with Star Entertainment Group (ASX: SGR).
In the unlisted space, late last year we saw Healthscope - Australia's only national private hospital - receive a covenant waiver that extended the life of its $1.6 billion loan from its lender.
Some companies will be stressed when interest rates go up and covenant relief disappears, notes Macken.
“Companies paying out more than they’re earning are living on borrowed time, and if the sky does fall in on these stocks, remember a debt holder and even hybrids have priority over shareholders when it comes to claiming assets,” says Macken.
The trouble with debt covenants is that while stocks are required to release their maturity dates, no register exists and companies typically don’t want to broadcast these dates any more than they have to.
As a result, some companies have only released their covenant maturity dates when it too late for investors to exit without loss.
Given the difficulty investors experience gauging the true health of any stock, it’s worth focusing on four vital indicators: net debt-to-equity, cash flow, profitability and funding.
Next week Azzet will use some of these key metrics to run a rule over ASX large caps with excessive debts on the balance sheet - and limited corresponding earnings or cash flow - that might be worth steering clear of.
Watch this space…
