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. 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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
![https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg](https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748-320-80.jpg)
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
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.
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
-
CrowdStrike IT outage: a global meltdown
Millions were affected by the CrowdStrike IT outage recently, which grounded flights and took the news off the air. Was this just a hiccup or a warning of much worse to come?
By Simon Wilson Published
-
Revolut finally bags a UK banking licence – what's next for the fintech?
Revolut has finally been granted a UK banking licence following three years of negotiations with the regulator
By Kalpana Fitzpatrick Published
-
UK mid-caps: an improving outlook
UK mid-caps have perked up and the rally may run further, but long-term investors should remain selective
By Cris Sholto Heaton Published
-
The tobacco industry is going smoke-free - how to profit from it
Tobacco companies have realised their traditional products are on the wane. But new opportunities have opened up – and should prove lucrative
By Rupert Hargreaves Published
-
Is it time to invest in creative industries?
Any industrial strategy should not overlook the creative industries, one of our top national assets
By David C. Stevenson Published
-
Is Mercia Asset Management set for success?
Mercia Asset Management helps the government fund smaller companies in Britain’s regions. Should you invest?
By Rupert Hargreaves Published
-
British stocks set for a boost
British stocks are due for a bounce as the UK looks more stable compared to many economies
By Alex Rankine Published
-
Ocado shares jump by a fifth
Ocado takes a turn for the better after attractive profit forecasts were announced
By Dr Matthew Partridge Published
-
The AI boom is on borrowed time
The hype around the AI boom could be on its way out – but why?
By Alex Rankine Published
-
Diploma: a blue-chip set for strong growth
Diploma, whose niche products include seals and fasteners, serves an array of growth markets. Should you invest?
By Dr Mike Tubbs Published