Company debt – how much is too much?

In order to grow, businesses have to spend – on new equipment, research, labour, materials, and a host of other things. Investing in the business now should theoretically mean improved growth later. Some of this financing might come from profits, but in lots of cases they’re financed by debt.

Over the last ten years, low interest rates have encouraged companies to take on more loans. Corporate debt rose by 6% between the end of 2019 and the first three months of 2021. Lots of that can be attributed to smaller businesses that took advantage of government schemes through the pandemic.

However, companies have been enjoying a low-rate environment for 10+ years. That’s plenty of time to rack up a hefty debt pile. Now that rates are rising, it’s important to consider how that will impact specific sectors and what we can expect moving forward.

Corporate debt and interest rates

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Source: Bank of England and Trading Economics, accessed 14/03/2022.

How much is too much?

Determining how much debt a company has is a relatively easy exercise. We tend to use net debt as a starting point to get an idea of a company’s financial standing. This is calculated by subtracting long and short-term debt from cash and cash equivalents. These are all found on a company’s balance sheet.

There are two things to keep in mind – trends and comparisons. These are a bit harder to grasp hold of. Knowing net debt on its own won’t tell you much. It’s useful to look at the direction of travel. Net debt that’s declining can be a good sign, particularly if it’s coming down from very high levels. Net debt that’s rising rapidly can be a sign of instability.

All companies have to invest in their growth, so rising net debt isn’t always a bad thing. It can be useful to compare net debt to cash profits (EBITDA) to get a sense of whether the company can afford its existing loans. This is known as the leverage ratio, and it tells you how many years it would take to repay a company’s loan obligations in full. Many companies set out targets for this ratio, but typically anything over 2.5 is worth a closer look to see if it’s cause for concern.

Leverage= net debt/EBITDA

As with all financial ratios, you need to compare similar companies in the same industry to get a sense of what’s normal. A tech company should have much lower leverage than an asset-heavy oil and gas company, for example.

A company’s size and age also play a part in what’s acceptable – younger companies will generally need to borrow more than their more established counterparts.

The many faces of debt

Once you have a rough idea of a company’s debt, it’s time to dig a little deeper. All debt isn’t created equally. This is truer now than ever, with interest rates on the rise.

Just as you pay interest on a credit card or mortgage, companies pay interest on their loans as well. The amount they’re paying is known as interest expense and can be found on the income statement. To understand how much of a burden interest payments are, you can divide operating income by interest expense to get the interest cover ratio.

Interest cover= operating income/interest expense

The higher the ratio the better, though it can vary between industries. Trends are important here. If interest cover has been steadily declining because interest expense is rising, it could suggest that debt is becoming unmanageable. This is something we’re looking out for in the current climate.

The Organisation for Economic Co-operation and Development (OECD) looks at companies’ ability to repay debt using a surplus ratio. This measures the size of a company’s debt repayments compared to its income after wages are paid. It’s the opposite to interest cover, so a larger number suggests debt that will be harder to repay. In the UK, it fell considerably between 2016 and 2019, but started to creep higher in 2020.

Surplus ratio for non-financial UK companies

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Source: OECD, accessed 14/03/22.

The interest rate on all loans will fall into one of two categories – fixed or floating.

Fixed-rate debt means interest payments have a certain, pre-arranged percentage until a specific time in the future. Floating rate debt means the interest payments will change alongside a pre-determined benchmark. This is often the Bank of England’s base rate or a measure of inflation like the Retail Price Index (RPI).

Over the past decade, the latter’s been beneficial because the rate’s tended to go down or roughly stay the same. But as rates rise, this might not be the case moving forward. Variable rate loan repayments linked to inflation or interest rates will become more expensive more quickly than those with a fixed rate.

You become the bank

At some point all loans, fixed or variable, will need to be repaid, at which point the company will either need to pay it back or take out a new loan. For most, that means refinancing at a time when interest rates are higher, and the result will be higher payments.

If a company doesn’t want to tie itself to a more expensive loan, they might look to investors. Issuing new shares can be a cheaper way to finance new growth.

During the pandemic, it offered financially strapped companies a lifeline. More recently it’s become a tactic to unwind costly debt and finance growth without added interest rate risk. And we’re expecting to see more of this if interest rates keep rising.

Money raised through new share issues (£ million)

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Source: London Stock Exchange, 28/02/2022. 

There are drawbacks for investors though. More shares in issue means profits are split between a greater number of people. If you already own shares, it means you now get a smaller slice of the pie. However, if the pie itself is growing, this might not be such a bad thing.

To get an idea of the balance between bank loans and shareholders, we look at debt to equity. A simple way to calculate this is to divide total liabilities by total equity. Both can be found on a company’s balance sheet.

Debt to equity ratio= total liabilities/total equity

In general, the higher the number, the greater role debt plays in funding the company’s operations. Too great a number can signal volatility ahead because interest costs have the potential to rise. Anything over two is worth investigating further.

Remember ratios and figures shouldn’t be looked at on their own, it’s important to consider the bigger picture. Past performance isn’t a guide to the future.

How to use debt when making investment decisions

No one is digging into corporate debt for personal enjoyment, except perhaps our share research team. These numbers can be put to work when you’re making investment decisions. Too much debt can be a drag on earnings because it’s costly to service. This becomes an even greater risk as interest rates rise.

Outside of comparing with industry peers and historical trends, it’s important to understand how debt financing fits in with a company’s strategy. It can be a necessary evil if large infrastructure investments are needed, so it’s useful to weigh up the benefits before making a final judgement.

It can be a laborious process, but our share research team can help do lots of the legwork for you. We cover a number of the most popular shares, offering research and insight on a wide variety of topics including debt. Sign up to receive our weekly Share Insights email.

This article isn’t personal advice, if you’re not sure whether an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value so you could make a loss.

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