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

Cryptocurrency roundup: bitcoin hits a new record high
Bitcoin & crypto

Cryptocurrency roundup: bitcoin hits a new record high

In the week when bitcoin hit a new high, we look at what’s been going on in the world of cryptocurrencies this week.
22 Oct 2021
Green finance is set to be the most powerful financial repression tool yet
Bonds

Green finance is set to be the most powerful financial repression tool yet

The government has launched its “green savings bond” that offers investors just 0.65%. But that pitiful return is in many ways the point of “green” fi…
22 Oct 2021
Andrew Hunt: why it's a great time to be a deep value investor
Value investing

Andrew Hunt: why it's a great time to be a deep value investor

Merryn talks to Andrew Hunt, author of Better Value Investing, about his adventures in the market's dark underbelly, looking for the hated and neglec…
22 Oct 2021
Equities are not a good inflation hedge
Economy

Equities are not a good inflation hedge

Institutional investors are definitely now worried about inflation. But they're not yet worried enough to flee to cash, says John Stepek
22 Oct 2021

Most Popular

How to invest as we move to a hydrogen economy
Energy

How to invest as we move to a hydrogen economy

The government has started to roll out its plans for switching us over from fossil fuels to hydrogen and renewable energy. Should investors buy in? St…
8 Oct 2021
How to invest in SMRs – the future of green energy
Energy

How to invest in SMRs – the future of green energy

The UK’s electricity supply needs to be more robust for days when the wind doesn’t blow. We need nuclear power, says Dominic Frisby. And the future of…
6 Oct 2021
The after effects of the gas-price shock
Economy

The after effects of the gas-price shock

In the wake of the recent spike in the natural gas price, we can expect slower growth, an industrial recession – and a newly assertive Russia, says Ma…
17 Oct 2021