Cineworld closure: don't blame James Bond, blame gearing

The crisis at Cineworld shows why it’s important to pick healthier firms when betting on the recovery, says Cris Sholto Heaton.

Cineworld wants to claim that it was the delay in releasing the new James Bond film that has forced it to close its doors indefinitely (see page 7). And to be fair, a shortage of big-budget releases, terrible government policies that have left many people with an exaggerated idea of the risks that Covid-19 poses to the average healthy person, and the imposition of evidence-free rules on wearing masks to irritate those who are still willing to visit the cinema has created a very tough environment for a business like this. But it can’t blame all its woes on somebody else.

A large part of the firm’s problem is down to high gearing. It had $4.2bn in loans at the end of June, and its liabilities rise to over $8bn including lease commitments. Equity was just $1.3bn, with cash of under $300m. Interest cover based on Ebit (see below) was 1.4 last year. Coming into the crisis, it lacked the flexibility that might let a firm with a healthier balance sheet stay open and pay its 45,000 employees (and so avoid shredding its reputation with staff and customers). It will probably now need to restructure to survive.

Prudent firms don’t pile on debt

This is a fine example of the danger of leverage. Using debt improves returns for shareholders in good times, but makes a business far less resilient. No company could have foreseen Covid-19, but they might have expected some sort of major crisis within a reasonable period: we tend to have one at least once a decade. Having less debt increases the chance of getting through unscathed and even being in a position to exploit the weakness of less prudent rivals.

All that said, if using higher leverage delivers better long-term returns on average, piling on debt might still be rational. Some leveraged firms will go bust in a downturn, but shareholders can diversify away that risk by holding a larger portfolio and still be ahead overall. Yet there isn’t much evidence to recommend this. Studies on how leverage affects returns are inconsistent, but on balance imply either no relationship or worse returns for companies with more debt. 

This suggests investors should err on the side of caution. If you can’t show that you are likely to earn a greater return in exchange for what is definitely a greater risk, the trade-off isn’t very compelling. This is particularly relevant right now, because badly hit businesses – real estate, entertainment, tourism, retail – will probably deliver the best returns in the recovery (see right). But this will only apply to those that get through. Many are in a lot of trouble. Some weak businesses will survive; a few always do. But at this stage, it makes sense to focus on the best of the worst. Cineworld won’t be last to falter.

I wish I knew what gearing and leverage were, but I’m too embarrassed to ask

Gearing refers to the extent to which debt rather than equity is used to fund an investment. The term can be applied to a business – which might issue bonds to help pay for the construction of a new factory or take out a mortgage to allow it to buy an office building – but equally to the use of borrowings by an investment trust or hedge fund to increase returns. Gearing is also known as leverage; the former is more common in the UK, while the latter is preferred in the US.

The extent of a company’s gearing is measured through ratios such as debt/equity. Let’s assume that a company has assets worth £100m and debt totalling £30m. Shareholders’ equity, which is equal to assets minus liabilities, will be £70m. Then its debt/equity ratio is 30 ÷ 70 = 43%. The debt/assets ratio, another common measure of gearing, will be 30 ÷ 100 = 30%.

The company then buys a rival firm for £50m and finances the deal solely through a bank loan. Total assets are now £150m, debt is £80m and equity is unchanged at £70m. However, its debt/equity ratio is now 80 ÷ 70 = 114% and its debt/assets ratio is 80 ÷ 150 = 53%. It is now more highly geared (or highly leveraged) than it was before.

You should also look at interest cover, which is earnings before interest and tax (Ebit) divided by interest payable on debts. So if the company had Ebit of £5m and paid £2m in interest, it would have interest cover of 5 ÷ 2 = 2.5. 

Gearing for an investment fund is usually calculated in a similar way to debt/assets. Say an investment trust has £100m in capital contributed by investors, borrows £5m and invests £105m. It will then start with gearing of 5%, which will change in line with the value of the investments.

The convention with hedge funds is to refer to leverage rather than gearing. Hedge-fund leverage can be complicated if the fund uses derivatives with high embedded leverage, but the simplest measure is to use the total value of the fund’s assets divided by its capital.

Recommended

Oil is taking a well-earned rest. But the bull market isn’t done yet
Oil

Oil is taking a well-earned rest. But the bull market isn’t done yet

The oil price has more than doubled in the last five years. It’s come off the boil recently, but in the longer term, things are still looking good. Do…
28 Jul 2021
Why you should treat whole-life insurance policies with extreme caution
Personal finance

Why you should treat whole-life insurance policies with extreme caution

Whole-life insurance policies are often marketed to people in their 50s and over. But there are significant drawbacks and you could end up with nothin…
28 Jul 2021
I wish I knew what an index was, but I’m too embarrassed to ask
Too embarrassed to ask

I wish I knew what an index was, but I’m too embarrassed to ask

The FTSE 100 is probably the best-known stockmarket index in the UK. But what exactly is an index?
27 Jul 2021
What’s behind China’s stockmarket meltdown?
China stockmarkets

What’s behind China’s stockmarket meltdown?

Chinese stocks fell hard for a third consecutive session on Tuesday. Saloni Sardana explains what’s going on.
27 Jul 2021

Most Popular

The MoneyWeek Podcast: Asia, financial repression and the nature of capitalism
Economy

The MoneyWeek Podcast: Asia, financial repression and the nature of capitalism

Russell Napier talks to Merryn about financial repression – or "stealing money from old people slowly" – plus how Asian capitalism is taking over in t…
16 Jul 2021
Why the UK's 2.5% inflation is a big deal
Inflation

Why the UK's 2.5% inflation is a big deal

After years of inflation being a financial-assets problem, it is now an “ordinary things” problem too, says Merryn Somerset Webb. But central banks st…
16 Jul 2021
An absurdly cheap healthcare stock to buy now
Share tips

An absurdly cheap healthcare stock to buy now

The pandemic has vastly accelerated the shift towards telehealth, making Cigna a long-term buy
20 Jul 2021