How investors can spot the next Carillion

The debt figure published in a company's annual report does not tell the full story. Phil Oakley shows you how to dig deeper – and avoid investment disaster.


Carillion had a huge portfolio of contracts but also a mountain of hidden debt
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The debt figure published in an annual report does not tell the full story. Phil Oakley shows you how to dig deeper and avoid investment disaster.

The key thing to remember as a shareholder in any company is that you get paid last. Before you get your share of a company's profits or assets, other creditors have to be paid first. That's why debt is often viewed as a scary word when it comes to analysing companies. Of course, borrowing isn't necessarily a bad thing, if the money is put to good use. The problems with debt arise when people or companies have too much of it. How much is "too much" depends on the ability of the company's income or assets to support its debt levels which also depends on investors having a complete picture of what constitutes those debts.

The recent collapse of support-services group Carillion is a classic example of a company sinking under the weight of its debt pile. However, Carillion also shows how a company can be far more indebted than it looks at first sight. The visible borrowing on a balance sheet is often just the tip of the iceberg. Other debts include things such as pension-fund liabilities, money owed to trade creditors, rental liabilities, etc. When you take these into account, companies can often be a lot more indebted than they appear. The more debt a company has, the more likely it is that interest payments will take up an increasing slice of its trading profits. If profits are growing, that isn't usually a worry. But when a business hits trouble and trading profits start falling, shareholders will feel the pinch. And if a company declares itself insolvent, shareholders may find it has so much more debt than they thought that there is no money left once all the lenders have been paid off. This is the fate that Carillion shareholders now face.

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So how can investors spot companies with dangerous levels of debt? The good news is that there's plenty of information in a company's annual report that can give the diligent private investor a good sense of what's actually going on.

Trawling through the accounts

In an ideal world, investors would not have to trawl accounts to find out exactly how much debt a company really has. And some companies are genuinely free of debt, which can make them very desirable as less risky investments. But for those companies that do have debt, it's not always clear cut how much there is. Most investors focus on net debt the total amount of borrowing, less the amount of cash on the balance sheet. The problem with this measure is that a balance sheet is just a snapshot of a company's financial position on one particular date. It might not be a true picture of what it looks like during the rest of the year.


Most companies choose a yearly date when their finances are at their strongest. For example, many retailers have December year-ends. That's because at that point they have received the cash from selling Christmas gifts, but have not yet paid their suppliers. This flatters their cash balances, while the amount they owe suppliers is classed as a "trade creditor" and not as debt. If you looked at the balance sheet at the end of January instead, the cash balance would probably be a lot lower. So be aware of this when looking at seasonal businesses such as retailers, airlines and tour operators.

A much bigger problem is when companies have big liabilities such as pension-fund deficits, or hidden debts. The promise to pay workers a pension based on a proportion of their final salaries can represent a huge liability. Many such schemes are in deficit (the assets of the pension fund are lower than the value of the pensions promised to employees). This is disclosed on the balance sheet. The trustees of the pension fund will insist that any deficit be plugged over time. This is usually done with cash payments to the scheme over a number of years. This is cash that cannot be used to pay dividends to shareholders, which is why a pension deficit should be viewed as being much the same as a bank loan.

So you should add any pension-fund deficit to outstanding borrowing to get a clearer picture of a company's debts but don't reduce debts if a fund is in surplus, as this surplus is unlikely to be available to pay off debts. Also, a pension-fund deficit can be expressed in two ways. One is the balance-sheet method described above. The other is the actuarial deficit, where the fund's assets and liabilities are calculated by a qualified actuary. These deficits can be much bigger than the balance-sheet figure. For example, BT had a balance-sheet deficit of around £9bn in 2017, but recent press reports speculate the actuarial deficit could be as high as £14bn.

Watch out for debt-like liabilities

Debt can also be hidden in joint ventures, deferred payments for buying other companies, and future financial commitments. But one of the most significant hidden debts often results from renting assets rather than buying them outright. This is common with high-street retailers. Buying dozens or hundreds of stores can cost millions or even billions of pounds, which would normally be funded with borrowing. By renting rather than buying, a company can avoid taking on lots of debt but instead, it may have to sign very long leases. Accountants argue these commitments are effectively debt-like liabilities that are hidden from investors and, from 2019, companies will have to disclose the value of assets they are renting on their balance sheets, as well as future rental liabilities.

Until then, we can estimate the value of these hidden debts (see"How to adjust debt for rented or leased assets", below, for how to do so). When these are taken into account, the true extent of company debts becomes much clearer. For example, WH Smith's balance sheet shows it has £4m of net cash. However, if debts are adjusted for its rented shops, then its true level of debt is nearly £1.4bn and it's far from being the only one.

An instructive case study

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Carillion's true debt levels
Row 1 - Cell 0 Balance sheetnet debtEbitdaOp cash flowShareholders'equityNet debt/EbitdaNet debt/op cash flowNet debt/equity
Headline figures£218.9m£280.9m£115.5m£729.9m0.81.930.0%
Adjustments:Row 3 - Cell 1 Row 3 - Cell 2 Row 3 - Cell 3 Row 3 - Cell 4 Row 3 - Cell 5 Row 3 - Cell 6 Row 3 - Cell 7
Additional average net debt£367.6mRow 4 - Cell 2 Row 4 - Cell 3 Row 4 - Cell 4 Row 4 - Cell 5 Row 4 - Cell 6 Row 4 - Cell 7
Pension deficit£804.8mRow 5 - Cell 2 Row 5 - Cell 3 Row 5 - Cell 4 Row 5 - Cell 5 Row 5 - Cell 6 Row 5 - Cell 7
Est. hidden lease debts£402.5m£57.5m£57.5mRow 6 - Cell 4 Row 6 - Cell 5 Row 6 - Cell 6 Row 6 - Cell 7
Joint venture net debt£370.7mRow 7 - Cell 2 Row 7 - Cell 3 Row 7 - Cell 4 Row 7 - Cell 5 Row 7 - Cell 6 Row 7 - Cell 7
Deferred consideration£71mRow 8 - Cell 2 Row 8 - Cell 3 Row 8 - Cell 4 Row 8 - Cell 5 Row 8 - Cell 6 Row 8 - Cell 7
Promises of funding to PPPs£63.4mRow 9 - Cell 2 Row 9 - Cell 3 Row 9 - Cell 4 Row 9 - Cell 5 Row 9 - Cell 6 Row 9 - Cell 7
Effective number£2.3bn£338.4m£173m£729.9m6.813.3315%

Carillion is a classic example of a company laden with understated and hidden debts. Studying its 2016 annual report makes clear that real debtlevels were more than ten times the headline amounts. Professional investors look at a company's ability to cope with its debts in various ways.Firstly, there's net debt to Ebitda (earnings before interest, tax, depreciation and amortisation). This measures how quickly a company's net debts could be paid off based on its gross pre-tax and pre-interest cash flow. Excluding financial, utility and property companies, a number below three is usually seen as relatively safe.

Secondly, there's net debt to operating cash flow. Ebitda ignores significant cash flows such as the timing of money received from customer bills, payment of suppliers, the cost of building up stocks, and pension-fund top-ups. As a result, operating cash flow is usually a better measure of a company's debt-paying capability it's closer to money that a company actually has available to pay its debts. Finally, there's net debt to equity: this measures debts as a percentage of shareholders' equity. Excluding companies that normally have high levels of debts (property, financial and utility companies) the lower this number, the better. If net debt is more than 100% of equity, then this could be a danger sign, and needs to be investigated.

The headline numbers in Carillion's 2016 annual report would have suggested there was little to worry about on these measures. Unfortunately this was not true, as the table overleaf shows. For a start, the company disclosed that its average net debt throughout the year was £367.6m higher than the year-end number. It also had a pension-fund deficit of £804.8m, and hidden debts from rented assets came in at £402.5m (see "How to adjust debt for rented or leased assets", below).Carillion's share of its joint-venture debts was £370.7m. Yet this was not disclosed on the balance sheet instead its share of net assets of £176m was shown (made up of £1.08bn of assets and £906m of liabilities). Then there was £71m of deferred consideration payments, related to businesses Carillion had bought in the past. And finally, commitments to finance its share of public-private partnerships (PPPs) came in at £63.4m.

Taking these into account, Carillion's true debt level was £2.3bn rather than £218.9m. Looking at its debt ratios on this basis (see table above) reveals the company was a financial basket case. Its level of debt relative to cash flow and shareholder equity was already very dangerous. Some hedge funds knew this and were betting on the share price falling.Yet at the end of March 2017 when the annual report was released, the share price was 219p, giving the company's equity (its market cap) at £940m. It's now worth just £60m. Hindsight is a wonderful thing, of course but any analyst worth their salt could have done this calculation in just 15 minutes.

How to adjust debt for rented or leased assets

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FTSE 350 retailers net borrowings and hidden lease debts
CompanyNet borrowingOp. leasecostHidden lease debt (op. lease cost x 7)PensiondeficitAdjusteddebt
JD Sports Fashion-£213.6m£167m£1.17bnRow 2 - Cell 4 £954m
Marks & Spencer£1.76bn£354m£2.48bnRow 3 - Cell 4 £4.2bn
Next£899.1m£225.6m£1.58bnRow 4 - Cell 4 £2.48bn
Sports Direct£34.1m£195.6m£1.37bn£3m£1.41bn
WH Smith-£4m£201m£1.4bn£5m£1.4bn

Credit-rating agencies adjust a company's debt levels and profits to account for rented assets. To estimate the equivalent amount of debt, they typically multiply the annual rent bill (or operating lease expense) by a number between six and eight. Multiplying by seven gives us an estimated value of hidden debt for Carillion in 2016 of £402.5m (see the first table above). If you do this for a range of FTSE 350 retailers, then you get the results shown below. As you can see, when you account for the rental liabilities, companies are lot more indebted than you think.

A rough-and-ready debt gauge

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Companies with high debt levels
CompanyMarket capDebt to marketcap. (inc. pen.def.)
Vedanta Resources£1,952m749.1%
AA plc£728m447.5%
Premier Oil£555m437.7%
Ei Group£605m373.7%
Trinity Mirror£210m260.2%
Gulf Marine Services£159m235.8%

A rough-and-ready debt calculation is to add a pension fund deficit to the existing net debt figure and compare it with the company's market capitalisation. A number over 50% is probably telling you to stay away. More than 100% is a sign of financial distress. The firms on the left breach those levels significantly. Interserve and Capita similar businesses to Carillion look unhealthy on this measure.

Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.


After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.


In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.

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