How much debt does it take to sink a company?

Taking on debt can give companies several advantages. But too much debt can be disastrous. So what is the tipping point, and what should investors watch out for? Tim Bennett explains.

If you've got a mortgage, or any other form of debt for that matter, you probably see it as a bit of a millstone. Quite right too. Until you've finally paid off the loan, you don't really own your home.

But when it comes to investing, debt isn't necessarily a bad thing. Companies often take on debt to fund expansion, for example. And it can have other advantages, as we'll see below.

But how much debt is too much? And what should investors watch out for?

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When debt makes sense

It often makes sense for a firm to borrow money, rather than raise it in alternative ways, because it's cheap.

Take your own finances.

The interest rate on your mortgage is generally a lot lower than the rate on your credit card.

Why? Because the mortgage is secured debt. If you don't pay it, the bank can take your house. If you fail to repay your credit card, the bank doesn't have any assets to fall back on.

It's the same principle for companies. As a firm, you can offer a lender security in the form of assets, such as property.

Also, by law, lenders are first in the repayment queue. Interest on bank loans must be paid before dividends can be dished out to shareholders. And if a company goes bust, lenders get repaid before shareholders canstake a claim to any leftover assets.

These two factors increase security for a lender, which makes the cost of borrowing lower than the cost of raising money from shareholders (by issuing more shares).

But there's another advantage too, which can be good news for shareholders the gearing effect.

How debt helps shareholders

Let's take a very simple scenario involving two firms. Each has balance sheet net assets of £100m.

The first firm is 100% funded by shareholder equity so shareholders invested this full £100m. The second is 50% funded by equity and 50% debt (carrying an interest rate of 10%). So shareholders invested £50m, while £50m is a loan from the bank.

Let's say both firms have a very good year and make enough profit to boost their net assets by £50m. So each firm now has net assets of £150m (£100m + £50m).

Now, let's say the two firms are liquidated (sold off for the value of their balance sheets) immediately. With the first firm, shareholders who started with £100m of equity will walk away with £150m. That's a nice profit of £50m, or 50% (£50m / £100m x 100%).

But it's even better at the second firm. It has net assets of £150m. After it is liquidated, it pays back the £50m debt and £5m of accrued interest (£50m x 10%). That leaves it with £95m. But its shareholders only invested £50m. So they've made a 90% return they've almost doubled their money.

How it can all go wrong

This example shows how using debt can boost your returns if things go well. Trouble is, it works in reverse too.Say there's a recession, and net assets, which started at £100m, shrink to £50m. The first firm's shareholders now have net assets of just £50m, when they had invested £100m.They are down 50%.

But they are still better off than shareholders in the second firm. If that firm's assets are reduced to £50m that's only enough to pay back the outstanding debt of £50m. After that there is nothing left.

So shareholders lose 100% of the equity they had invested a year ago.

The message is simple: debt can boost your returns, but it also magnifies losses in bad years.

This means that the more debt a firm carries, or - to use the technical term - the higher its gearing (the amount of debt it carries relative to equity funding), the riskier it is asan investment. That's because high gearing means that earnings figures will be more volatile. That usually means a more volatile share price too.

Which sectors tend to carry lots of debt?

In theory any firm can take on debt, but some are more likely to than others. The answer depends on many factors.

However, probably the most important is cash flow, and how this matches up to a company's planned rate of expansion. For example, food retailers like Tesco often don't take on lots of debt to open new shops, as they already generate lots of cash from customers.

Telecoms firms, on the other hand, need to build lots of expensive infrastructure before they can make any money. That often means taking on lots of debt, especially if they are racing to grab market share in new countries.

Construction firms are also often heavily indebted as they need to invest in buildings a long time before they receive cash from sales.

In other words, what might be a high level of debt in one sector might be perfectly normal in another. So the key to assessing whether a firm is carrying too much debt, is to compare its gearing levels to the sector average.

You also need to judge how strong its cash generation is can it keep getting cash in from customers? If it doesn't have cash coming in the door steadily, it won't be able to pay interest on its debts.

How to test for debt distress

A useful ratio for looking at debt is interest cover'. You can calculate it yourself or pick it up on most investment websites. In effect, it looks at how many times over the firm could cover its interest bill with its profits.

It's a bit like you comparing your net salary each month to your monthly mortgage interest bill. The more times the former covers the latter, the better.

So if a firm generates profit before tax of £100m, and has an interest charge of £50m, interest cover is two times (£100m / £50m). The higher the better.

For me, two is the absolute minimum safety level. I'd rather see three or four times, but then I am fairly cautious. By comparison, a triple-A credit rating, the highest available from a ratings agency, usually requires a firm to have cover often times or more (and of course meet lots of other criteria).

Of course, this isn't the only measure you should be looking at if you're thinking of investing in a company. We've run through several others in this series already.

But it will give you a good idea of just how financially secure a company is. And in the current unforgiving environment, that's an absolutely vital piece of data to check before you invest in anything.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.