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High debt levels a red flag for equity investors

Glenn Freeman  |  12 May 2016Text size  Decrease  Increase  |  

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Glenn Freeman is a senior editor for Morningstar.


Even well-respected, blue-chip companies can introduce unacceptable levels of risk into your investment portfolio. This is why a focus on fundamentals should underpin any investment portfolio.

Many individual investors also pay a financial planner or other trusted adviser to help them decide which asset classes and specific stocks they should invest in.

However, there are a number of red flags every conscientious investor should check for before adding a company to their portfolio. A high level of balance sheet debt is one of these.

"There are indicators. You look at the financial metrics--cash flow, profitability in the balance sheet metrics," says John Likos, a senior credit analyst with Morningstar.

He says information about company exposures to debt should be contained in most annual and half-yearly reports.

"It's rare that [such debt exposure] happens out of the blue, without a gradual deterioration--or some type of graduation over time," Likos says.

"Look at cash balances, debt balances. If you look at the metrics, are they getting better over time, or are they getting worse? Cash flow is the one metric that I particularly like to look at--the free cash flow versus operating cash flow."

There are numerous examples, both globally and in Australia, of highly capitalised, successful companies being undone by high debt exposure. Dick Smith is a prominent home-grown example.

Slater and Gordon (SGH) is another.



A key beneficiary of Australia's deregulated legal services market, Slater and Gordon floated on the Australian Securities Exchange in 2007, becoming the world's first listed law firm.

An over-emphasis on growth by acquisition is one potential warning sign Likos mentions.

"Often you'll find, particularly with roll-ups, they grow by acquiring ... and they take on too much debt to do this. Highly acquisitive transactions should always raise red flags that are worth investigating further."

Amid the M&A activity of Slater and Gordon, its acquisition of UK-based legal services firm Quindell in 2015 was a major turning point. According to Likos, the most obvious risks lay not only in acquiring a law firm in a foreign market, but also in the scale of the target company.

"To then borrow your own market-cap puts a lot of strain on the group. Slater and Gordon had an approximate market cap of $700 million. They then went and bought a company that also had a market cap of $700 million, and funded it all with debt," he says.